Usually the answer I get when I ask the question above is, “so I can grow my retirement account”. Although this is a good answer, it’s not the real reason why it is so important is to make sure that you are achieving adequate return. The true answer is one word:
There truly is no better time than now to talk about inflation and the impact it can have on your goals. With all the “stimulus” and government spending we can only assume that in the future our economy will experience significant inflation.
So what is Inflation? Well the simple answer is this: The standard assumed average annual inflation rate is 3%, so if I were to go out and buy a box of pencils for $1.00 today, in one year that same box of pencils will cost $1.03. As you can see, the purchasing power of my dollar has been reduced! I can no longer go out and buy a box of pencils for just a buck.
Inflation is caused by many things but the looming cause for our future inflation is monetary policy. When the government passes out “stimulus” essentially they are adding additional dollars to the market which eventually dilutes the value of the dollars already out there.
Let’s use an example, say you are washing your white clothes at home. Every once in a while you will probably use bleach to help restore the whiteness to your clothes, but to keep from burning holes through the fabric you add water to the bleach to dilute it, the more water you add to the bleach the less potent the bleach is.
If bleach is like buying power then adding water is like adding dollars to the market.
The more dollars you add the less buying power there is! Eventually retailers will have to raise their prices to compensate for the fact that each dollar is now worth less, or the bleach is not as strong as it use to be. And that my friends is inflation.
So why do you have to worry about return… because if you only generate a return that is equal to inflation, your money will only be able to buy you the same amount of stuff that it did last year! If you want to be successful on your savings pilgrimage you have to earn a return that beats inflation.
Let me insert a little disclaimer here, chasing return is a very dangerous thing. This topic is an entire blog post in of itself, but suffice to say that I am a proponent of buy and hold strategy unless you are a professional investor. I’ll write more on this topic at a later date. As a savings pilgrim I want to always be conscious of the return I am earning on my path to financial freedom. I want to be sure that the investments I am using are falling in line with my risk tolerance and my mountain top goals. The only way to tell if the investments are working the way I want them to is through careful measurement and giving adequate time to let them work. Occasionally, I might have to adjust my path to success.
Inflation is a bear and no one knows when it will kick in from the great recession, but it will. Be aware and prepare yourself for the need to generate increased returns.