Editor’s note: This article was first published in October 2013. Its 2.5% annual inflation assumption, and the idea that 2.5% can still be earned on fixed income such as bonds and deposits, reflect conditions around 2013; inflation and interest rates have moved a lot since, including the 2021-2023 inflation spike.
Inflation is savers’ great enemy, and for many of them it’s also a very quiet one, since they barely take it into account.
Savers who don’t want to take any risk often sit on cash, without realising that this is a risk in itself, because of the corrosive effect of lost purchasing power.
Wealth isn’t measured by the money you have, but by the goods and services you can buy with that money. In all likelihood, €1 today, like $1, will lose more than 35% of its purchasing power over the next 25 years.
That’s why investing your money becomes a necessity if you want to preserve your wealth and purchasing power for the future. In other words, if you don’t invest because of the risk, and leave your money in a bank account or under the mattress for the long term, what you’re really doing is making an investment that’s losing you money.
Savers aim to preserve their wealth, while investors aim to preserve their wealth and also grow it. They may seem like two different goals, but the first is a necessary condition for achieving the second, and the second is a necessary condition for the first to work.
In periods of moderate inflation you might be able to overlook this factor, but in the long run, inflation remains the most persistent threat to the goal of preserving and growing wealth.
How to fight inflation
To be on the safe side, always assume annual inflation of 2.5%. That’s the minimum annual return you need to earn on your savings. Some people are willing to take on more risk, while others aren’t ready for it, so a 2.5% return can still be found in fixed income (bonds, deposits and so on).
That said, I always remember that in the stock market, if we invest for the long term in shares that pay good dividends, the dividend will be our fighter in beating inflation.
Whether we invest in fixed income or equities, compound interest will be the most important part of our strategy for growing our wealth, and therefore our purchasing power.
To get an idea: when we talk about compound interest, we’re saying that a small amount of money earning a modest return can turn into a large fortune over time. Inflation works exactly the same way, only in reverse: a large fortune that loses a modest amount of purchasing power over time can cost you a large part of that fortune. Bear in mind that money is just paper, and what counts is how many things you can buy with that paper.
I’ll say it again: never ignore the erosion caused by inflation, however insignificant it may seem.
Further reading
- 12 things millionaires know that you can learn
- 4 things I learned from being broke
- The best books on getting rich are over 70 years old and tackle the real problem
Featured image: Bundesarchiv, Bild 102-00104 / Pahl, Georg / CC-BY-SA 3.0, CC BY-SA 3.0, via Wikimedia Commons.
