Understanding the effect of inflation on your money will help you to realize the importance of investing to maintain your purchasing power. By not doing anything with your money means you’re actually losing money each year.
Inflation Explained
Inflation is the percentage that goods and services increase each year.
For example, if an apple costs $1 and inflation is 3 percent, the next year the apple will cost $1.03 (1 x 1.03 = $1.03).
This may not seem like a big deal but if you apply this inflation to larger priced items over a longer time frame, you can see how important it is to grow your money through investing.
For example, if a window costs $800 and inflation is 3 percent, the next year the window will cost $824 ($800 x 1.03 = $824).
If you put $800 in a savings account and earn interest of 1.2% you would make $9.60 so you would have $809.60. The cost of the window has increased more than the increase in money in your savings account.
Therefore, the value of your money or your purchasing power decreases over time as inflation is applied to all goods and services around you. This is why understanding the effect of inflation on your money is so important.
Keeping your money in a savings account will not get you ahead of the game, financially speaking. Many savings accounts offer a 1%to 2% interest rate or less so with inflation currently at 6.8% your money is losing value by 4.8% to 5.8% a year. As a side note The Bank of Canada generally tries to keep inflation at around 2% a year.
Investing to Overcome inflation
You need to invest to grow your money more than the rising cost of goods and services or inflation. On average, the S&P 500 has returned 10 percent a year making your investment return higher than inflation. You can buy a S&P ETF which tracks the performance of the S&P 500 index. This index is made up of 500 companies in the United States. ETFs are usually composed of a group of stocks so they’re less volatile than owning individual stocks.
For example, if you put $800 into the S&P 500 Index fund and make 10 percent then you’ll have $880 ($800 x 1.1 = $880). You will have grown your money more than the cost of the window at $824, improving your purchasing power.
As a warning, the S&P 500 Index fund will not return 10 percent each year but over many years. One year it may return 20%, the next 3%, the next -8% and over time the return is 10% on average. This is the average return over the past 50 years.
Using a TFSA account for this type of investment may be your best option. I wish a TFSA account was available to me at 18 years old and I had the financial know-how at that time to start investing. Refer to TFSA blog post to learn about the benefits of this account.
Safe Investing and using Dollar Cost Averaging
The earlier you start investing the more your money will grow. Time in the market is one thing that you can’t get back so use your age to your advantage. I would open a TFSA at 18 years old using Questrade or another self-directed account to invest in ETFs. The stock market will increase and decrease throughout the years but over the long time it generally increases. You can invest $6,500 a year into a TFSA. Have money automatically go into your TFSA each paycheck. The amount of money you put in will depend on your expenses.
You should base it off your budget. Start at about 25 percent of your monthly income and increase it if possible. For example, if you make $1,000 a month then you put $250 into your TFSA each time. Of course, you’ll have to adjust your contributions based on your budget for needs and wants.
Each month you buy the same ETF. Make sure not to sell your shares when the stock market is going down. When the stock market decreases continue to buy shares to average down on the purchase price of your shares.
For example, you use $250 to buy the S&P 500 ETF at $80 giving you 3 shares. The fund decreases to $60 so now you only have $180 ($60 x 3 = $180). You lost $70.
Next paycheck use $250 to buy more at $60 giving you 4 more shares for a total of 7 shares.
Now you’ve decreased the price at which you bought your shares from $80 to $71.42 ($500 / 7 = $71.42).
If the ETF increases back to $80 you’ll have $560 ($80 x 7 = $560) in your account meaning you’ve now made $60 dollars on your original $500 investment.
Eventually, the stock market will recover and make new highs. Having ETFs will also decrease your anxiety and stress levels when the market is down. Trust me on this.
I hope this blog gives you a good understanding of the effect inflation has on your money and why you should be investing to increase the value of your money.
| This blog is for general information and educational purposes only and is not financial advice nor should it be substituted as professional advice. Before taking any financial action based upon any information, you should consult with the appropriate professionals. THE USE OR RELIANCE OF ANY INFORMATION CONTAINED ON THIS SITE IS SOLELY AT YOUR OWN RISK. |
