You know when you go to buy a shiny new phone and the salesman says to you, “only $100 a month with our new promotion!” That’s $100 less than the other carrier was going to charge. Woop woop! All of a sudden that salesman looks great - a new best friend. Your smile is bright, your bag is ready, and then your new best friend comes to the register to tell you that a few fees are tacked on to that initial $100. A service fee, an activation fee, a monthly fee, a why-did-I-decide-I-needed-a-new-phone fee. All of ‘em. Well, turns out that the $100 dollars you were going to save isn’t worth nearly as much as you’d expected. And the new best friend you thought you made looks more like a new enemy that will haunt you every month in the form of auto-pay.
Inflation: What’s that?
Now, inflation isn’t the same as fees, but they are similar in that they both end up costing you a little more money than you’d previously bargained for. I’m sure we’ve all heard of inflation, but if you’re lucky enough to never look at the news, I’ll explain inflation for you.
Simply put, inflation happens when the value of a country's currency begins to decline while the cost of goods and services begins to go up. Your cash isn’t worth what it used to be, and it buys you less than it once did. Instead of avocado toast, you're going for buttered bread. We’ve all been there. Buttered bread tastes better anyways.
Inflation is like anything else in the economy - cyclical. It’s natural, like childbirth - even though both are scary and tend to cost us money in the long run. There will never be a time when inflation ceases to exist, just like there will never be a time that children cease to exist. And as annoying as both of them are, we kinda need them.
That's because a certain level of inflation must occur to keep us spending money instead of saving it all the time. Saving sounds great, and we definitely want to do it, but if we never did anything else the economy could never grow. So inflate a little, spend a little. Then deflate again, like the smile on your face before and after you get the receipt at the phone store. Normal.
Inflation-Adjusted-Returns: What’s That?
Inflation-adjusted returns are like the wise-old crones of investment strategies. They have the same attitude as a divorcee watching fresh newlyweds. They know where they will most likely end up, and they know what it’ll cost them, so they stay prepared.
When you measure your return on investments, the initial numbers might be great, but not entirely accurate. If the investment has been sitting for long periods of time, inflation has likely had a chance to seep into your savings (much like the spouse you have divorced) and make the return worth slightly less than anticipated. Since inflation causes currency to decline in value, the return on your investments might be slightly less valuable than you are led to believe if you look at it from the perspective of currency value at the time you first began investing. By adjusting for inflation, you can gain greater insight into how much your return is truly worth. This way, the actual and accurate earning potential of your investments is exposed.
Why Does It Matter?
Well, we all have one ex that we wish everyone told us was a little worthless. But instead, our friends let us “be happy” and we went on believing they were worth a million bucks. Turns out they’re worth a couple of hundred headaches and one divorce attorney. Sigh.
Adjusting for inflation regularly helps us weed out the worth of our investments, and determine how valuable it is for them to stay over the long term. You might have an investment that earned 4%, but we discovered that inflation was at 3% during that growth period. You think you’re walking home with 5% gains, and you’re left with 1%. Worst case scenario, your investments show a return of 2% while inflation went up 3%. This return becomes a loss, and failing to monitor it over time could accumulate greater loss if inflation shows no signs of correcting itself.
So, adjusting for inflation means better understanding your rate of return and making correct decisions based on the correct information. The best part? It’s cheaper than a divorce attorney.
What It Means
I never want my clients to feel like they are going through a scary divorce, and I definitely want to help save you money if you already had one. One of the best ways to do that is to stay on top of your money and what your money means in real-world context. Part of the real-world context is remembering not to forget the past (except for that ex and those few nights in college that we don’t need to talk about). Remembering the history of currency value at the time of investment and comparing it to currency value now is essential to making sure your investment returns mean exactly what you believe they do. If you gained 5%, we don’t want you to find out 4% means %1, and we definitely don’t want you to find out it means a loss.
Inflation-adjusted-returns, the wise-old-crone of investment strategies, will remember the past for you, and keep you in check with it.
That completes our blogs for this month, and I hope it helped you more than it overwhelmed you. Stay tuned for next month to be helped and/or overwhelmed once again on a brand new series.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
Investing involves risks including possible loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if
sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax.
Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may
not achieve its investment objective.
Options are not suitable for all investors and certain option strategies may expose investors to
significant potential losses such as losing entire amount paid for the option. The fast price swings in currencies will result in significant
volatility in an investor’s holdings. Any company names noted herein are for educational purposes only and not an indication of trading
intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.