Don't Forget About the Bite of Inflation
Let's face it. No one really wants to chat about inflation. But unfortunately, inflation can have a devastating effect on your wealth and your purchasing power over time. In plain English, inflation eats away at your money and reduces your standard of living. The general theory is that the price of goods and services increases over time, so a dollar buys less.
Ibbotson & Associates, a financial research firm based in Chicago, calculates that the rate of inflation has been approximately 3% since 1926. This means that you lose 3% of your purchasing power every year. For example, one dollar today will buy only 97 cents worth of merchandise next year. In two years, that dollar is worth only 94 cents. Over 30 years, that dollar is worth only 41 cents. You can perform this uplifting calculation by multiplying the product of the first number by 0.97, thirty times, or you can use a financial calculator or spreadsheet program.
The important points in the preceding paragraph are that your money loses value over time, and you need to earn more than 3% on your money, just to stay even. When you consider rates of return, you must consider a number of factors. First, there is a nominal rate of return; this is the rate of return you earn before taxes and before inflation. Second, there is the real rate of return; this is the rate of return after inflation but before taxes. If the rate of inflation is 4% and you earn a 9% rate of return, your real rate of return (return after inflation but before taxes) equals approximately 5% (9% minus 4%).
But, then there's Uncle Sam. Continuing our 9% example, suppose you pay federal and state income taxes at a 30% rate. On a 9% rate of return, you would pay 2.7% (9% multiplied by 30%) in taxes. Your nominal rate of return after taxes equals 6.3% (9% minus 2.7%). But, we have to consider inflation. Continuing the example where inflation equals 4%, we must further reduce the rate of return by 4%; so the 6.3% becomes only 2.3% (6.3% minus 4%). In this example, the real rate of return after taxes equals 2.3%. Since this return is positive (your return exceeded the rate of inflation and tax rate), you grew your money and increased your purchasing power.
While we are on the subject of inflation, let's consider cash investments such as money market accounts and U.S. Treasury bills. For this example, let's assume the interest rate on these investments is 3.5%. Considering income taxes at a 30% rate, we must pay 30% of 3.5%, or 1.05% to Uncle Sam; this leaves us with 2.45% (3.5% minus 1.05%). If inflation equals 4%, then in effect we lost money.
Cash investments can be worthwhile because they bear relatively little risk and offer a relatively stable source of cash (both principal and interest). These types of investments are beneficial (suitable) for emergency funds, money you need in the short term, and when you are risk averse. But, when you consider the effects of inflation and income taxes over the long run, you are likely to have a negative net return on this money.
So, if you are planning for the future, it is worthwhile to consider allocating some portion of your portfolio to growth-oriented investments: assets that have the potential to increase in value (appreciate) relative to inflation over the long term. These include investments such as equity mutual funds, which can decrease in value over the short term but have historically provided returns well above the rate of inflation.
Investing for growth can help you build wealth over time.
The writer, Joseph Gelb, is a CPA and attorney who co-authored the Personal Budget Planner A Guide for Financial Success and authored How to Build a Million Dollar Service Business (Small Business Advisors, www.smallbusinessadvice.com).
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.