From the Desk of Robert Simpton CFP
Updated: Sep 13, 2022
Financial Planning for Inflation
The returns on your investment consist of two different components: the rate of inflation and real rate of return. Inflation is how much the cost of things that you buy have increased over time. You want to be able to at least buy the same things in the future as you can buy today. If you need more money to buy the same things then that price increase is most likely from inflation. The whole point behind investing is to be able to buy more things in the future with the dollars that you invest today. You want your investment to increase in value over time. If your rate of return is the same as the inflation rate, then in reality, you really did not grow your money because, even though you have more dollars, those dollars are only enough to buy the same things as you could when you started and nothing more. A higher rate of return than the inflation rate allows you to buy more than you could before so your investment grew and the rate that it grew is the Real rate of return. If the rate of return is lower than the inflation rate, then in reality you lost money because you can only buy less than you could when you started.
Inflation is an important part of financial planning because we want the money in today’s dollars to buy the same things in the future in those future dollars. I typically use 2% as an average inflation multiplier because that is where the Federal Reserve tries to maintain it. Like expected rates of return, the reality in the future is likely higher or lower in any given period of time. We cannot predict the future but we can account for these variables in this way.
The rate of return that you experience is made up of two parts: Inflation and the Real Rate of Return. If the inflation rate is 2% and you experience a 2% rate of return on your investment then it really did not grow but only stayed the same in so far of what you can buy with those same dollars. In this instance, many savings account interest rates decrease the value of your investment because their return is lower than the inflation rate. If you would like your money to grow and work for you, then your returns on your investment should be more than the inflation rate.
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