Personal Finance 

Remember Inflation in Investing Projections

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Do you ever hear people proclaim that if you invested $100 in the stock market today and it appreciated 11% for the next 30 years, you’d have almost $2,300 at the end? It seems as though people can remember inflation when making short term decisions (such as whether or not to invest in a particular bond or certificate of deposit), but it seems to disappear from the discussion whenever long term decisions are made.

That was the premise of my friend’s article on salary increases, how people tend to forget about inflation when projecting salaries over many years and I think that applies even more so to investing. See, when you invest $100 today and it appreciates 11% to $2,300 in thirty years, you have to keep in mind that $2,300 in 2036 won’t represent the same amount of purchasing power as it does in 2006 – that’s because of inflation. At 4% inflation, your $100 investment is worth around $761 in purchasing power because it really appreciates at 7%, not the full 11%.

I believe that most people (unless you’re a politician, because those guys still don’t have every tax number tied into inflation yet) understand the concept of inflation, the hidden tax, and I hope this just serves as a subtle reminder about its pervasiveness and that you should remember it when you’re doing long term projections (especially if you’re doing long term projections).

{ 6 comments, please add your thoughts now! }

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6 Responses to “Remember Inflation in Investing Projections”

  1. eROCK says:

    Why did you choose 4% as the number for inflation? I’ve heard many people use 3% and even one investor I know uses 6%. I think 4% is a fair (realistic) number, but I’m curious what others use and how they came to using that particular number.

  2. jim says:

    3% is the one you hear the most because since 1900, consumer prices have increased at about that rate according to the Economist. I use 4% because I was adding a little fudge factor.

  3. MMM says:

    But there are some technological advantages. I’m listening to a $15 portable CD player and the sound quality is better than what my father could afford 30 years ago.

  4. Paul says:

    seriously inflation is the biggest problem facing the american economy (and other countries right now). Everyone feels wealthier due to large wage increases and skyrocketing home prices over the past decade but unfortunately inflation has been skyrocketing also, nearly double digits(look at your medical, educational, utility bills). Inflation has been drastically understated as the government cannot afford to increase cost of living adjustments for SS and other programs, not to mention its a very clever way to tax the american people. Think about it, the average joe gets his 5% raise and blindly follows the 3% number, so then he thinks he’s doing ahead. And I bet you most people would feel better if they got a 7% raise, with 10% real inflation rather than 2% raise with 1% inflation, because they don’t really think about inflation and the way it is made to seem better than it is.

  5. Matt says:

    The effect of inflation on purchasing power depends a great deal on what one tends to purchase. For me, for my entire life to date (and for the foreseeable future), inflation has not been a significant factor, because the price of everything I pay for except taxes, housing, and energy has been going consistently down…and those are a relatively small part of my budget. Plus, now that I own instead of rent, the price of housing isn’t going to go up either.

    But I’d bet those 3-6% numbers won’t hold more than, at most, 12 years. One way or another, when the Trust Fund fraud is exposed so blatantly that even Democrats can’t continue perpetrating it anymore, we’re going to see some inflation that’ll make the 70s look like the 90s.

  6. Anonymous says:

    Never forget that inflation is devaluation of the currency. The price increases that we use to measure it are a symptom. In the end, our government controls the currency by how much they print and the interest rates the Federal Reserve sets. That control is inexact.

    Inflation is a tool for devaluing debt denominated in the currency. In other words, our federal government owes a certain number of dollars. By inflating the number of dollars, they decrease their value. Paying off that debt becomes easier.

    Feel free to guess how serious our government is likely to be about fighting inflation in the future.

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