Friends Don’t Let Friends Ignore Inflation

by A Blinkin on March 21, 2012

Lets say you have two friends. One of your friends keeps stealing money from the other. Wouldn’t you feel an obligation to warn your one friend about the other? Of course you would! It’s the same obligation I feel when I think about your money and inflation. There’s an invisible creature among us that continues to diminish our hard-earned dollars, but for whatever reason many people continue to ignore it.

A Riddle For You 

Take the two friends we created above and lets add a third: Adam, Christina and Ceelo (I promise these names are completely random; I’m not watching The Voice). Adam, Christina, and Ceelo each purchased a home for $1,000,000 in three successive years and then decided to sell the home one year later.

  • During the year of Adam’s ownership, the country experienced a period of 10% deflation. A year after the initial purchase, Adam sold his home for $920,000.
  • During the year of Christina’s ownership, the country experienced a period of 10% inflation. A year after the initial purchase, Christina sold her home for $1,080,000.
  • During the year of Ceelo’s ownership, the cost of living stayed pretty much the same and she sold her home for $980,000.

The Million Dollar Question

Who fared the best?

Most people would see the $80,000 gain for Christina and immediately think she came out on top. Most people will also see Adam’s $80,000 loss and immediately think he fared the worst. It’s understandable to think this way, but it’s completely wrong.

Adam is actually the only homeowner to make money. During a a period of 10% deflation, Adam increased his purchasing power by 2%  while Christina and Ceelo each settled for a 2% loss.

Why This Is Dangerous

According to Economist Richard Thaler:

A person who invests $10,000 today in the stock market will have about $67,000 in twenty years, assuming a 10% average annual return, whereas a person who invests $10,000 in U.S. Treasury bonds earning 6% a year will have about $32,000.

Now lets account for inflation:

Assuming average annual price hikes of 4%, the stock investor would have the equivalent of $32,000 in today’s buying power after two decades had passed while the bond investor would have less than $15,000.

This is the exact reason why I laugh at those “investing” all of their money in CDs. Ignoring inflation could be a greater risk than stomaching the swings in the stock market.

Will you do me a favor and promise not to let your friends ignore inflation?

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