In my post Growing Your Tax Refund  much earlier in the year, an anonymous commenter noted that I didn’t account for inflation in my comparisons. I bring this up again (this has been brewing in the drafts for quite some time) because with the Federal Reserve opening the spigots with QE2 , a lot of people are thinking about how inflation might be affecting them. In my post, I compared how your average tax refund could be increased based on what you did with the money (other than spending it).
An anonymous reader noted that I ignored inflation in my comparisons (it wasn’t relevant as I was comparing several options against one another), but in general I’m not terribly concerned with inflation. In fact, I can safely say that I honestly don’t care about inflation because:
- I can’t control it.
- It affects everything equally.
By definition, inflation is the change in your money’s purchasing power, specifically the decrease in your money’s purchasing power. It’s why $100 in 1980 is worth $264.12 (BLS’s inflation calculator ) and why a million bucks fifty years ago (1960) needs to be more like $7.3 million today.
While it’s important to remember that inflation exists, there really isn’t anything you can do about it. You save money in a certificate of deposit, despite its interest rate being under the historic inflation rate, because it’s better than zero. The best CD rates  for a 1 year CD are less than 1.50% APY. I’m pretty sure, and we can confirm with by looking at CPI figures, that inflation was higher than 1.50% but that doesn’t matter. A 0% checking account lost even more.
What you should actually do is compare your investment with a “safe” investment over that same time period and decide whether the added risk is worth it. When companies or individuals invest capital, it’s always with an eye towards the “safe rate of return.” The rate you get above that is a risk premium. The rate of inflation is almost irrelevant.
When you choose where to invest, the investment matters as much as how it fits in your overall plan. The stock market might beat inflation but any financial expert will warn that if you need your money in the next 3-5 years, don’t put it in the stock market. The market can go up as quickly as it can go down and that higher rate of appreciation (risk premiuM) comes at a cost.
It’s important to consider inflation when building your overall financial plan, but it’s not a consideration for every single investment. Your overall plan needs to beat inflation but not ever investment needs to overcome that hurdle. So, the next time someone throws around the idea that you need to worry about inflation or you need to beat inflation, think about how much it really matters and when.
What do you think? Am I completely wrong (yes, it’s happened! ask my lovely wife!) and how do you think of inflation?