Tuesday, March 24, 2009

The Lifting

I hope the previous posts on personal finance weren't too annoying.  It's a topic I really enjoy, and think about far too much.

I still warmly remember a special one-time class I attended right before graduating Wash U.  It was just over an hour long, but was one of the most useful things I ever did at the university, even though it was completely optional.  The prof just gave a lot of useful money advice that served me incredibly well over the next year: stuff like the difference between student loans and credit card debt; whether, when, and how to buy life insurance; why it's important to start saving immediately for retirement; and other pearls of wisdom.  I've been kind of surprised by how rare it is to find such simple, basic, useful advice out there that isn't dedicated to selling a particular stock or otherwise encouraging financial wizardry that most of us are far better off avoiding.

I deliberately kept the previous posts as simple as my loquacity would permit.  They are intended to be read in sequence as a core explanation of how one person (yours truly) looks at money, and offer a baseline for setting up your own system.

This is the first in a second series of posts.  Much like everything else on this blog, their primary purpose is just to provide an outlet for whatever I'm currently thinking about.  As such, each post will be a single topic, and can be read in any order, either before or after the core personal finance posts.  Because I'm a financial layman (i.e., everything I write is my own opinion, and you shouldn't use it as the basis for any of your own important financial decisions), I hope to keep the writing fairly high-level and accessible.

So: the topic of the day is inflation.

I think all of my readers already understand the basic idea behind inflation.  Inflation is when the dollar becomes less valuable, so that it buys less than it did before.  The classic example is movie tickets.  Back in the days of the nickelodeon, you could attend twenty features with a single dollar bill.  When I was growing up, tickets were a dollar at the second-run theater, and a few dollars at a first-run theater.  During the brief three years that I attended Wheaton North high school, I witnessed a steady rise in the ticket prices at AMC Cantera 30 theater.  Ticket prices hovered right below $10 for quite a while before finally breaking the line, and now is moving inexorably higher.

It's very useful to think about inflation when planning your finances.  The biggest concern is retirement.  If you started working in 1960, and wanted to save enough money to watch one movie a week, you may have erroneously planned on spending $0.50 a week when you retired in 2005.  Your actual GOAL wasn't to save enough to spend $0.50 a week; it was to save enough to watch one movie a week.  As a result, you would have needed to save enough money starting in 1960 so that you could withdraw $10 a week in 2005.

Inflation is less a concern when saving for a short-term purchase.  Except for a few brief periods, like in Germany after World War I or, to a lesser extend, in the United States during the 1970s, inflation rarely has a major impact from year to year.  There may be an inexorable rise of 5% in prices from year to year; after 45 years that will be a total of 544%, but next year would just be 5%.  Plus, you can't easily predict what inflation will be for the next year.  I find it easier to budget for the current price, and plan to overshoot it by some small amount, so I'll be prepared for any changes in cost.

All of this is a bit of an oversimplification, though.  People tend to talk about inflation as if it was a constant thing that affected everything; people talk about "prices" going up.  The fact is that each individual thing has its own price, and in any given year some of them will be going up and some will be going down.  Cars are getting cheaper.  Eggs are more expensive.  Houses are less expensive.  Phones are more expensive.  Gas is less expensive.  Newspapers are more expensive.  Internet access is less expensive.  "Inflation" is a summary of what is going on in the entire economy, but we aren't buying the entire economy or some idealized basket of goods: we're buying specific items.  Because of this, it's entirely possible that your dollars might be getting more valuable (you can buy more of the things you want) while the rest of the economy's is getting less valuable (dollars are buying fewer of the things other people want).  Don't pay too much attention to the headlines talking about what prices or the dollar are doing.  Think about the things that you buy, both on a daily basis (what's the cost of gas?  Of bread?  Of your heating bill?) and as special purchases.

A further complicating factor is that the QUALITY of goods is also changing.  The best example here is electronics.  From about 1980 until about 1998, the cost of a computer was remarkably constant, generally a little under $2000.  Obviously, though, a 1998 computer was significantly more powerful than its 1980 counterpart.  Not because of megahertz or RAM or another abstract measure: because the 1998 version could, for example, contain an entire encyclopedia; could play every card game ever created; could play a movie; could play Beethoven symphonies and Bach concertos; could store every photo you had ever taken; and so on.  Now, from an economist's perspective, there is still just a single good called "the computer".  The fact is, though, that a dollar spent on computing today is giving you far, far more than a dollar spent on computing a decade ago.

What about deflation?  Right now, several economists are publicly worrying about the prospect of falling prices.  We haven't had deflation in the US since the Great Depression, but it was fairly common in the period between the Revolutionary War and World War I.  Most economists and historians hate and fear deflation.  Why is this?  Well, imagine that you could buy a house today for $200,000, or you could buy the same house in a year for $100,000.  Which would you rather do?  Many people choose not to buy today if they think they can get a better price tomorrow.  This is an excellent move on the individual's part: they're just making a rational decision and getting maximum benefit from their money.  But, what happens when every person in the entire economy makes the same decision?  For a whole near, nobody buys a house.  Every realtor loses their job.  Companies stop building new houses.  Carpenters and electricians lose their jobs.  All these unemployed people stop going out to eat, which means that waiters and waitresses lose their jobs.  The cycle spins outward, with rising unemployment and shrinking revenue.

Inflation has the opposite problem.  If you can buy a new computer for $500 today, and know that it will cost $1000 tomorrow, you will be strongly inclined to purchase it now.  This spurs spending, which is good for the economy and bad for individuals.  The salesman will get a nice bonus, he'll buy a new watch, the watchmaker gets more money, the watchmaker hires a gardener, etc.  You personally are in great shape if you're getting use out of the computer and not going into debt.  But, if you put it on your credit card, then you've been driven to set aside your personal goals and driven into spending that you would otherwise have deferred until a better time to buy.

All things considered, most historians and politicians seem to think that the best situation is steady, mild, predictable inflation.  This encourages consumers to spend and grow the economy, leading to more opportunities.  That's why people are so scared about deflation.

I have to put in one final note.  Anyone with a 401(k) has probably seen what I think of as "The Awesome Chart."  This is the scenario that goes something like, "Alice starts saving $100 a month when she's 25 and stops when she's 35.  Bob starts saving $100 a month when he's 35 and saves until he retires at 65.  At 65, who has the most money?"  The answer is Bob, and this is a pretty cool indication of the immense power of compounding interest.  An initial investment of $12000 can do much better than one of $36000 if it was made earlier.

I do like this chart, because it conveys the importance of starting to save early.  I also dislike it, because it downplays the importance of inflation.  Most people's incomes will steadily rise over time - partly because their careers advance, but also because salaries generally track with inflation.  So, that $100 a month may be a pretty large share of your salary early on, but 45 years later, it will probably be a much smaller share, even if you are in the same career.  It would be far more accurate to look at what happens if you contribute a steady percentage of your income over the same periods.

Unfortunately, that's impossible to do.  We can't even track inflation from year to year, let alone one individual's career path and earnings growth.  As with all financial models, any time you make something simple enough to understand, you're no longer describing the real world.

So!  That's inflation.  It's something to be aware of and plan for.  To protect your own assets against inflation, you can try these strategies.
  • Choose inflation-indexed investments, like Treasury Inflation Protected Securities.  Don't put ALL your money in these, but some as a hedge may be a good idea, especially if you are in or near retirement.  The value of these investments will automatically grow (or shrink!) along with inflation, so your real buying power should remain consistent.
  • Buy real, appreciating assets.  The best example is a house - historically, houses have tended to change prices more or less at the same rate as inflation.  You won't get rich, but the value should be fairly safe.  (Again, this is true over the long term - as we've seen, year-to-year fluctuations can be enormous.)
  • Buy stock.  Companies directly benefit from rising prices, since they're the ones charging them.  Changes in inflation are usually directly reflected by changes in stock prices - of course, they will still be moving up or down based on how an individual stock or the broader economy is doing.
  • Put your money in a savings account.  This won't be as good of a protection for your principal (the amount you invested), but banks do usually raise their interest rates during periods of high inflation, and lower them when prices are steady or low.

Because of inflation, don't rely too much on the following strategies.
  • CDs.  What happens if you lock in a 3% APR for the next 10 years, and then we experience double-digit deflation for each of those years?  The real value of your dollars when you take them out will be much less than when you put them in.  This isn't at all to say that CDs are a bad strategy - they can be great, especially if you get a high rate and then prices go down - but you don't want to put all your eggs in one basket.
  • Bonds.  The same reasons for CDs apply here.  If a bond's yield was set during a period of low inflation, then it becomes relatively less valuable during a period of high inflation.
  • Dollar bills, money in your mattress, or a checking account.  Your money won't have any chance to grow in response to inflation, and will lose value every day.
  • Gold or other commodities.  Again, inflation isn't really a constant - some things will be getting more valuable, others less so.  It's entirely possible that inflation will skyrocket and the value of gold will plummet. 

Hm, anything else to write before I sign off?  I'd say keep inflation in mind, especially when planning for far-off goals like retiring, but don't worry about it too much, mainly because worrying doesn't do any good.  Prices will go up or down, and you can't know in advance which they will do.  Don't worry about the things you can't control; instead, focus on the ones you can.  Are you irked that oranges are twice as expensive now as they were last year?  Look around the produce section and see if some other fruit is cheaper.  Are you agonizing over buying a stereo because you don't know whether the price will go up or down?  Don't worry about it.  Focus on whether you actually need or want it.  If so, figure out when would be a good time to buy it.  If it would be better to save and wait, then do so.  If it's on sale now, it'll be on sale again in the future.

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