Inflation

THIS IS A SOMEWHAT NERDY point, but the loss from inflation is slightly different from an investment loss. To understand why, suppose you have $1,000 and your favorite candy bar increases in price by 5%, from $1 to $1.05.

Previously, your $1,000 would have bought 1,000 candy bars at $1 each. If the price increases by 5% to $1.05, you might imagine that you have suffered a 5% loss of purchasing power, and thus your $1,000 would buy just 950 candy bars. But in fact, at $1.05 each, your $1,000 would buy 952 bars, plus you would get 40 cents in change.

How does this look mathematically? If you had a 5% investment loss, you would multiply your $1,000 by 0.95. But to gauge the impact of 5% inflation, this would be the calculation:

1/1.05 = 0.952

The implication: 5% inflation (0.952) isn’t quite as damaging as a 5% investment loss (0.95).

What if inflation ran at 5% a year for 10 years? You would multiply 0.952 by itself nine times, which is easy to do with a financial calculator. Result: Over 10 years, the purchasing power of your money would shrink by 38.6%—or, to put it another way, the buying power of $1 would be reduced to just 61 cents.

Next: Nominal vs. Real Returns

Previous: Investment Costs

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