Inflation is basically the rise of general prices across the country. In Canada, the inflation rate for 2016 was approximately 1.5%. Since our Canadian prices have risen by 1.5%, the purchasing power of each Canadian dollar has decreased; each dollar can buy a fewer amount of goods. Specifically, every product we would want to buy would require an additional $0.015 for every dollar spent. Not much, right? If something costs $100 last year, because of inflation, it would now cost an additional $1.50. For consumer products, inflation probably doesn’t seem to make a difference. For example, you would only notice the price increase in a Tim Hortons coffee if you buy coffee often! Even big ticket items costing $1,000 would only increase by $15. Relatively speaking, inflation doesn’t make a big difference for consumer goods. Over time though, which is highlighted when we look at carton of eggs costing $0.31 in 1935 and now $2.94, the cost of our consumer goods are likely to increase drastically over the decades to come.
A lot of investors talk about trying to ‘beat the market’. I would encourage people to, at a minimum, beat inflation. If you can find a way to ‘beat’ the inflation rate than you have actually grown your money over time and maintained a purchasing power for the goods that you may end up needing to buy one day, for yourself or a loved one. For example, if you want to be able to buy a car in 15 years from now, inflation will likely cause the price of that car to increase each year. So a $10,000 car today could cost an additional $2,502.29 (assuming inflation stays at 1.5% each year) 15 years from now. One purpose for investing money is to ensure that your nest egg is able to buy the same bundle of goods in the future. How do we beat inflation?
You are sure to fail to beat inflation by keeping your money in a savings or checking account. For example, a High Interest eSavings Account at RBC yields approximately 0.5% per year. So, if you have a nest egg of $10,000 in a High Interest eSavings Account, your $10,000 would grow by approximately $50 at the end of the year! However, the price of everything else has risen by 1.5%. If you take the nominal interest rate, which is the 0.5% promised by the bank, and subtract the inflation rate (1.5%), which gives you a real rate of return, the value of your nest egg actually decreased by 1%! You’re $10,050 that you earned this year really be like having approximately $9,899.25 at the end of the next year. By ‘investing’ in a low yield account you are actually losing value each year. Imagine how much value you’re losing by keeping your money in a bank account that earns less than the High Interest eSavings account! What if you never start investing, there may be trouble.
Although the impact of inflation on consumer goods may not be major, it has a significant impact on investments! One way to look at inflation is as a decrease in our purchasing power. Since goods are costing 1.5% more each year, our Canadian dollar is buying 1.5% less of goods each year. This basically means the power of our money is falling by 1.5% per year. So, if you have $4,000 CDN in a basic savings account, the ‘value’ of that $4,000 is falling by ($4,000 x 0.015) $60 per year. If you buy Tim Hortons coffee everyday at $1.70, that’s like losing out on 35 medium double doubles every year! What’s worse is that inflation can fluctuate from year to year, but the Bank of Canada tries to keep inflation manageable at a rate of 1% to 3%. What should investors do?
One way to possibly beat inflation is to invest in index funds. An index fund is like a mutual fund at a fraction of the cost. It may seem penny pinching to compare high cost and low cost investments, but when it comes to percentages every penny counts! Another good place to start is a mutual fund, but there are better investments out there in Canada and abroad!
Remember, to protect the value of your Canadian Dough, you just need to beat inflation!