Adjusting for Inflation

Does a 10% return on investments mean your purchasing power goes up by 10%?

To understand the power of compounding interest and the effect of investment returns to your bottom line, it's important to understand inflation: the erosion of purchasing power over time.

On The Rich Moose, I have talked, and will be talking a lot more about Inflation Adjustment. All returns over long time periods must be adjusted for inflation so you can meet your financial goals.

What is Inflation?

Inflation (economic): The rate at which general prices for goods and services are rising, and, consequently the purchasing power of a specific currency is declining.

Over time we know the price of goods and services goes up. In Canada, a stable, well-run country by international standards, the cost of things doubles roughly every 30 years. If 30 years ago you could buy a 12-pack of national brand budget beer for $10, today that same 12-pack will probably cost around $20.

That's because the Bank of Canada—the central bank which controls the Canadian dollar—has decided a long time ago to focus their monetary policy on inflation control.

Smart academics (who are probably not as smart as they think) have decided that an inflation rate of 2-3% a year is ideal to promote growth and spending without inducing panic caused by prices going up too fast or going down. The academics and central bankers believe they can create stability through control of the currency.

If prices go up too fast people have a tendency to hoard stuff that doesn't spoil. Why? Well, if a can of Cola that costs $1.00 today will be worth $1.20 next month, why not buy all the Cola you can get your greedy little hands on right now?

What is Deflation?

Deflation is the opposite of inflation. Instead of prices moving higher, in a deflationary environment prices for goods and services drop. This means the currency in questions gains purchasing power.

If the prices of stuff goes down people also panic. Just consider the somewhat recent housing crashes in Japan, the USA, Ireland, Greece, Spain, Portugal, and many other countries. What initially started as prices going down a bit because of affordability/financing issues quickly spiraled into a panic where people got rid of their houses as fast as possible. Every month people stayed in their houses meant their net worth was dropping by thousands of dollars.

It's psychologically difficult to hold onto an asset that relentlessly declines in value month after month. Why buy a house now for $400,000 if you can buy it next month for $390,000?

In Japan overall prices have declined or remained stagnant for several decades. It has done significant damage to their economy and government finances as people eventually earn less, become less productive, and spend less money on goods and services.

Good luck asking your boss for a raise when he has to drop his prices every month. Try asking the lady at the bank for a home loan with a 5% downpayment when the price of houses is going down 10% each year.

Due to the psychological effects of declining asset prices, price deflation can bring economic growth to a halt quickly.

Adjusting Investor Expectations

As stated above, the Bank of Canada currently focuses their policy effort on keeping inflation in the 2-3% range. With this information, we can somewhat safely assume the value of a Canadian dollar will decrease by 2.5% each year over the long term.

This is not a certainty! Shocks can and do happen, even to large and seemingly stable countries. But for our purposes it's the best we can do with the information we have.

When investing, if we deduct 2.5% off our expected total return on investment we get our expected "real return" (or inflation-adjusted return) on that investment.

That's why I use the 6% return estimation on my assumptions for a more aggressive investment strategy. The total return might actually be closer to 9%, but the impact of inflation will reduce the true return when it comes to how we an actually spend that money.

When we adjust for inflation in our calculations, we are simply adjusting our numbers to make sure that $100 today will buy the same amount of stuff as $100 down the road. No loss of purchasing power. Adjusting for inflation is a must for long-term planning.

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Start Saving Young

Thanks for checking out The Rich Moose! I started writing this blog earlier this month after teaching myself WordPress and designing the website last fall. I enjoy writing (thanks Raymond Welch!) and I really want this blog to share my personal experience with money. I don't care about search engine optimization, ad revenue, marketability, or any of that stuff. When you share this content, with your help I hope I can inspire other young Canadians to actually care about their financial future.

Your Facebook and Instagram feeds scream spend money, have fun, and live for now. I'm saying yes... but living large now is going to bite you in the ass hard down the road.

Government benefits for seniors are alright. One way or another you will have $17,000 a year to live on if you're older than 65, but $1,400 a month means couponing, basement suites, and stay-cations.

The Time Value of Money

Who is going to have more money when they're 65?

  • Sarah who graduated at 23, lives frugally for 10 years putting away $1,000 a month during this time and then never adds to it or touches it again, spending her whole paycheque from the time she's 33 to 65? or...
  • Matt who graduated at 23, parties for a few years, settles down and gets serious, and puts away $1,000 a month starting at 35 years old saving diligently for 30 years? or...
  • Jake who also graduated at 23 who decided to save a steady $500 a month for the entire 42 years?

They all end up with the same actually. About $1.1 million if their money compounds at 6% returns. However, Sarah only actually contributed $120,000 while Matt contributed 3x as much. Jake was right in the middle at around $250,000. Because Sarah started saving early and put the magic of compounding gains to work for her, she got nearly $9 in investment returns for every dollar she contributed!

The key to wealth and financial stability is investing money as early as possible, keeping your investment costs low, and avoiding investing mistakes by following a good investment strategy. While it's ideal to save tonnes of money when you're young like Sarah, it could mean sacrificing the things you want to do. Matt had all the fun he wanted, but ask anyone in their 40s how easy it is to begin saving money. It's not, especially when you spent your 20s and 30s splurging on everything in sight, maybe racking up some debt in the process.

Steady and consistent investing at a young age, while shunning debt, is the easiest path to long-term wealth. Save and invest as a habit and let the markets do the rest of the work for you.

Realizing the Benefits of Saving

I read about the time-value of money a long time ago—probably when I was in my early teens. Looking at that compound interest curve, I was instantly hooked. Yeah I am a nerd...

I grew up in a family where money was not always plentiful. I distinctly remember there being no money for groceries numerous times. The stress of bad financial decisions is intense and consumes everything. I swore back then I would never put myself in a similar situation as an adult.

Next week I am planning to share my first Investment Asset post. I'm think I'm a pretty humble, down-to-earth, boring guy so don't take this the wrong way as I don't mean to be a braggy pants. I hope that by seeing our real numbers, you can see it's possible to accumulate wealth at a young age.

The market value of our investment portfolio goes up and down quite a bit from day to day, but it should land somewhere in the range of $460,000 (not including work pensions). Saving this amount of money with our own two hands took a lot of work, some sacrifice, and we've said "no" to more things than I can remember.

While I certainly regretted some things looking back, overall I can't say we're really missing anything. We've got a long life ahead of us and we're way ahead of the game.

I'm happy to say, despite some mistakes and being in our mid-twenties, my wife and I don't have to save a nickel anymore and we'll be filthy rich. At 50 years old we'll have over $1.75 million. At 65 over $4.2 million. That's inflation-adjusted dollars without adding another penny... ever.

At this point living prudently is a sort of lifestyle for us. We're both happier when we have less crap to worry about. It's psychologically freeing to confidently be able to say "no" and only do the things we really want to do.

A much better writer than I, Jim Collins, calls it F-You Money and I'm proud to have it.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.