Author: David Berky

Article:
" Inflation is the overall or specific increase in the cost of a
good or service."

Thank you, Mr. Dictionary.

Inflation is when your mom or dad complains about the prices
they have to pay nowadays compared to what they paid when they
were a younger.

"I remember when a candy bar only cost a nickel." "I used to buy
gas at that station for 15¢ a gallon." "When did milk get so
expensive?" "You paid HOW much for your home?"

Inflation in America has been relatively steady. There have been
some periods of high inflation, such as was seen in the 70's,
but on average inflation in the US has been steady at about 3%
for the past 30 years. Some countries have experienced inflation
above 1000% in a single year.

The 3% figure is also pretty close to the average as you go
further back in US history. So we will use the 3% figure as we
discuss the effects of inflation.

A detailed analysis of the cause of inflation is beyond the
scope of this short article, but we can mention some things that
tend to cause inflation.

Increases in government taxes and fees can lead to inflation
(especially when businesses are taxed). When the cost of
business goes up, product prices go up. When prices go up your
income effectively goes down. Then you have to work harder or
find a better job. Or hope that your employer will give you a
raise.

Which then makes the business costs go up and so prices go up
and so on.

Also when your personal income taxes, property taxes, sales
taxes, auto registration fees, etc. increase you are forced to
live on less or hit the boss up for a raise.

If you get your raise (and several of your co-workers also are
given raises) the cost of doing business has gone up. The
business will then pass the extra costs on to their customers -
inflation.

Inflation can also be caused by scarcity. If there are only a
10,000 Beanie-Babies, "Tickle-Me-Elmos", "Chicken-Dance-Elmos",
or what ever the current toy-craze is, and there are 100,000
people that want one, the price is going to go up.

If mad-cow disease causes cattle ranchers to destroy large
portions of their herds and there is less beef on the market,
the price of beef will go up.

If interest rates go up, inflation can also result. If it costs
more to borrow money, the cost of doing business has gone up and
so will product and service prices.

For the last 10 years inflation has been relatively low. It is
my uneducated opinion that inflation has been minimal because
people have relied on the stock market boom of the 90s to supply
extra cash. Also many people have taken on additional debt
rather than curtail their spending.

But people can only stand so much debt. Once you are maxed out
on your ability to pay (you may never max out your credit limit
as long as you keep paying on time), you will either have to
reduce your lifestyle, beg for a raise or find a higher paying
job.

I predict that once the majority of middle-class America is
saturated with debt, inflation will begin to rise or the economy
will stagnate for years until some of the debt is paid down or
people's homes appreciate so that they can borrow more money
against them. (Yes, you will be getting further into debt, but
at least you can buy that new boat.)

For the most part, regular, steady inflation has little effect
on our day-to-day living. Most people get a pay raise every year
or every other year that either keeps pace with inflation or
helps them move a bit ahead.

But when you are looking at the long run and making long term
plans, inflation can have a big impact.

For example if you are 30 right now, wouldn't it be great to
retire with a million dollars when you are 60. You could live on
that forever. Right?

Well, let's factor in just 3% inflation for 30 years and see how
much your million will buy then. After 30 years of 3% inflation,
one million dollars will buy about $400,000 worth of goods and
services. That's 60% of your money gone to inflation.

If you were counting on a monthly retirement amount of $2778
each month for 30 years, you now only have the equivalent of
$1111 each month. Less than half! Could you live on $1111 a
month?

Sure you may have your home paid for and you won't have to buy
expensive work clothes or pay for lunch every day, but your
medical bills will go up as you get older and your insurance
costs will increase. Also you may want to golf or travel more
than you do now. You will have more time for hobbies; how will
you pay for them?

The biggest problem I see with a lot of long range financial
planning, especially retirement planning, is that people forget
to factor in the effect of inflation on their investments and
savings.

You may be able to live on $2778 a month at today's prices, but
could you live on $1111 at what prices could be 30 years from
now.

So what can you do about inflation? Really nothing. It is out of
your hands.

But when planning for the future you can include it in your
calculations. If you want to live on the equivalent of $2778 a
month when you retire 30 years from now, you need to plan to
save/accumulate $1.8 million and have it invested at 5% after
you retire and want it to last 30 years.

That means that if you are earning 11% (as the stock market has
averaged for the last 30 years) and you are 30 now, you will
have to invest $500 each month to achieve this goal. If you only
invest $100 a month you will need an average return of 18.4%.
(If you can average that, you should be managing the world's
money!)

A good financial planner will understand the effects of
inflation and help you plan for them. But I suspect that some
less-trained "planners" (who are probably more like salespeople
in a financial planner suit) tend to "forget", ignore or don't
understand in the first place the effects of inflation.

Leaving it out of the plan makes the calculations easier and may
even help them get more "sales" because you are not discouraged
by the truth. And their "product" (investment) may not seem as
inadequate as it may really be.

Another quick way to account for the effect of inflation is to
subtract the inflation rate from any rate of interest you will
be receiving on an investment. So if you are going to assume a
3% inflation rate and the assumed rate of return is 11%, do the
projection with only a 8% rate of return or interest.

This will give you a more accurate picture of the value (not the
amount) of the investment at its maturity.

Some investments such as real estate and precious metals (gold,
silver, etc.) actually benefit from inflation. This may make you
want to truly "diversify" your portfolio into more types of
assets, not just more types of stock.

Inflation does not have to be scary as long as you understand
how it works and how it affects your future money values.
Accounting for it in financial equations and projections can be
done simply. But overlooking it or downplaying its effects can
cause you to miss your financial goals by a wide margin.

About the author:
© Simple Joe, Inc. David Berky is president of Simple Joe, Inc.
One of Simple Joe's best selling products is <A
href="http://www.simplejoe.com/moneytools/index.htm">Simple
Joe's Money Tools - a collection of 14 personal finance and
investment calculators</A>. This article may be freely
distributed so long as the copyright, author's information and
an active link (where possible) are included.

Find the market wizard - FREE membership today!

Learn Forex Trading