Inflation is misunderstood by many common investors. They think that it would rip them off their savings completely and leave them with lesser value. The truth is that inflation affects the value of your money negatively, but when controlled, it isn’t a major problem. Cash lying idle beneath your mattress will be the worst affected by inflation. However, if your money is channeled to a quality investment instrument, you will be surprised with the results.
What has investment got to do with inflation?
Investing means channelizing your idle money into a fruitful direction that will hopefully bring you a good return. If you get an investment instrument that will give you 5% return next year, you will be getting 105% of your principal. If you invested $100 today, this instrument will bring $105 to you by next year.
However, if the rate of inflation is 7%, then you are not making any money at all, even with a handsome 5% return. In fact, you will get a return of -2%. Instead of $105, the value of your investment will be $98. Inflation has eaten away all the return you could have earned and even 2% of your original investment.
If you want to keep your money safe, then you have to find an investment instrument that can provide at least as much return as the rate of inflation. If the instrument in our example provided a 7% return, then the value of the principal would have remained steady. No loss will be recorded. However, if the instrument provided 8% returns, the value of the investment will be in the positive zone.
Inflation is not your enemy, but it isn’t a friend either
If you never thought about inflation before, you may just be happy getting 5%. After all, you get $105 after a year. You don’t realize that the value or purchasing power of this $105 has reduced.
When planning for the long term, you should definitely keep inflation into account as it slowly erodes the value of your investment. However, inflation is not your enemy. In fact, it is the consistently rising prices that help you in achieving the returns from your investments.
With rising inflation (controlled by the central banks) people get the incentive to spend their money today, rather than saving it for tomorrow. When spending increasing, manufacturers get the incentive to produce more.
After all, the materials will cost less today than tomorrow and they know that demand is being generated for the present, not for the future. When applied to several million people and thousands of businesses, this means economic growth.
Ideally, when economic growth is good, most investment instruments (if not inherently flawed in design) will perform well. This will help you get better returns too.
In one way, inflation balances the returns you get on investment. So, make sure that you keep the inflation rates handy for reference each time you invest your money. This will help you in balancing your portfolio and getting better returns, regardless of the economic cycles.
I set this blog up a couple of years ago now as a way to share my experience that I’ve gained through my school education and my real life education. It sounds geeky, but the economy is something that I’m really passionate about and it’s something that I am actually pretty talented in, so it’s great for me to share these experiences with those that may be struggling a little bit with finance and figuring out how to navigate the economy.