How inflation erodes your investments

What is Inflation?

The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time (see Inflation - Your money's worst enemy).

Due to the huge inflation, the Zimbabwe's bill below can not even buy a donut!

How can Inflation affect me?

The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return (%) their investments need to make for them to not to lose money on an investment

Suppose you can buy a good for $10 today and inflation rate is 5% an year. Theoretically, 5% inflation means that next year the same good will cost 5% more, or $10.50.

Regarding your investments, if the inflation rate it's not considered, your rate of return is a nominal rate of return and not the real rate of return.

The Real Rate Of Return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time.

For example, if you invest in a fund that pays you interest of 5% per year and the inflation rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your savings only increases by 2% during a one-year period.

Let's follow the example:

You could calculate the return from $10,000 invested at a nominal interest rate of 10%, with a real interest rate of 7%, accounting for inflation, for 20 years with interest compounded annually, using this formula:

Future value (FV) = 10,000 x (1 + rate of return) ^ period of time

Using the nominal rate of return you'll get:

FV = 10,000 x (1 + 0.1) ^ 20 = 67.275,00

Using the real rate of return, i.e. accounting inflation, you'll get:

FV = 10,000 x (1 + 0.07) ^ 20 = 38.697,00

A very meaningful difference, isn’t it? So, whenever choosing investments it would be wise to always consider inflation and determining the real return rate your investment will have.

In conclusion

If the inflation rate is significant, your investments return rates will be smaller than the announced nominal interest rates. Savers will lose out if nominal interest rates are lower than inflation rate.

As inflation erodes your investments, you should consider it when decide between investments options since there is a meaningful difference between real and nominal return rates!