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Inflation: Public Enemy Number 1

by Rajen Devadason

Inflation is taxation without legislation.

Milton Friedman

To set the stage, please allow me to paint a word picture for you that, sadly, might seem all too familiar...

A regular guy, whom we'll name Alan,  was a person who wanted to play it safe. While conservatism has its place in many areas of life, in this instance, Alan's 'cowardice' cost him dearly.
 

While Alan's cowardice-driven conservatism did NOT cost him his physical life, it did cost him his long-term economic life - meaning his financial wellbeing - because soon after the onset of his retirement, Alan's meagre lifetime savings ran out too quickly.

Two factors contributed to this sad state:

1. Alan's natural conservatism caused him to park his savings in instruments that were safe but which yielded very low returns.
Result: Insufficient portfolio growth over the decades.

2. General inflation eroded the buying power of the small stash he did manage to set aside.
Result: The cost of basic necessities spiraled out of control, thus accelerating the rate Alan 'devoured' his funds.

We all know people like Alan who shudder  at the thought of taking any kind of risk with their money. Because of that, as explained, they tend to keep all of what little they can save in safe, but dismally yielding instruments.

There is a place for capital preservation, but take note of a powerful relationship at work over the long haul that rewards intelligent investment risk-taking and penalises those who play it too safe.

It's called the risk-reward relationship, and is a cornerstone of modern investment science.

Without going into mind-numbing mathematical formulae, let me just define it simply:

The risk-reward relationship essentially states the more investment risk you are willing to stomach, the greater the eventual monetary reward you should be able to expect over the long haul.

In normal, day-to-day English usage, the word 'risk' when associated with money sunk into some investment or savings vehicle means the danger of not getting it back when you need it. But to investment professionals, the word 'risk' has a subtly different meaning. The relative 'riskiness' of an asset is reflected by its volatility, especially over the short- and medium-term.

The problem therefore with super-safe investments or savings instruments, such as the bank deposits Alan and his cohorts or likeminded friends favour to the exclusion of all else, is that these instruments tend often to generate compounded growth rates that are lower than inflation.

If you park $100 in a bank account that yields 2%, but inflation rages around you at 3%, you will lose ground to the tune of one percentage point per year. And imagine if your personal inflation rate is double the official rate, then in your own life, you will be losing your battle against inflation at the staggering rate of four percentage points each year. (Explanation: If your personal inflation rate is 6%, say, and your money in savings is growing at 2%, then 6% minus 2% equals 4% a year.)

Continue to do this long enough and you could end up in the poor house. Which is what I meant earlier in saying Alan received his just desserts for cowardly behaviour.

Bottomline: Alan played it too safe, and it cost him dearly.

But that doesn't mean conservatism is bad! Exercised correctly, it is good. For instance, the world's greatest stock picker is generally regarded to be Warren Buffett, at the time of this rewriting the world's richest man. In the world of high finance, Buffett's value investing approach is deemed pretty conservative by others who prefer racier investment mixes.

Buffett's success stems from great intelligence, great discipline and a great commitment to learning. (If you too would like to commit - only to yourself - to a long-term programme of enhancing your ability to understand investing, financial planning and economics, help yourself to my free ebook, 26 Books To Take YOU All The Way To The Top!)

Buffett once wrote, "The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income tax during years of 5 percent inflation. Either way, she is 'taxed' in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital."

The great economist Milton Friedman puts it even more succinctly, "Inflation is taxation without legislation."

As far as you and I are concerned, the bottomline is that in the game of investing, taking the trouble to learn about the science  and art of growing your money is the best way to work on enhancing your investing inclination over the course of several years.

As you do that, you will be laying a solid foundation for long-term financial success because investment success is correlated to intelligently derived investing inclination.

People like Alan tend to find themselves retired and poor because, at the end of the day, not taking any risk at all is the greatest risk of all!

However, the solution is NOT to dive headlong into investing your precious, hard-earned money without forethought. No! The solution is to take time to learn how to save your money more aggressively and at the same time invest time, effort and mental focus on learning about the various forms of investment risk. To help you with both goals, read these two articles, which I've written for you:

How to Start Saving Money

Investment Risk - Understanding and Profiting From It!

Finally, if you live in Malaysia or are a Malaysian expatriate working elsewhere but are eventually planning to return to Malaysia and think you might like my help in the realm of financial planning and retirement planning, you may learn more about me here.

© Rajen Devadason