InflationThe fourth article in this Investing 101 series for beginners talked about how to buy and hold; how to diversify; and how to think globally. If we do this, and keep costs low, we will earn more money, and we will keep more of it than the average investor.

This article discusses another important way in which you can really screw up with investing. You can fail by not understanding the effect of inflation over time. It can sneak up on you”but not if you’re looking right at it.

Inflation

Historical inflation in the U.S. from 1914 to 2006 has been (on average) 3.43% a year. Sometimes more (a lot more in the 1970s!) and sometimes less. But that’s the average over the long term and we should expect something similar for inflation over the next few decades, too. Who cares? I hope you do.

Over the course of one year, you can hardly notice inflation. Your weekly grocery bill that was about $100 last year will be about $103.43 this year, if inflation stays at 3.43% annually. No big deal.

Even after five years at 3.43% annual inflation, your same weekly grocery bill will only be $119.37. Still no big deal, right? But after ten years of this inflation, what was your $100 weekly grocery bill is now $140.11, and after 20 years it’s just about doubled from $100 to $196.30 to buy the same groceries each week.

Well, hopefully every year you are getting a raise. Hopefully it’s at least keeping pace with inflation. If not, you are actually falling behind each year, gradually losing real purchasing power.

But, with rare exceptions, your investments aren’t getting a raise. The value of the original investment money you put in is gradually getting diminished. Whatever your investments are, whether cash savings, bonds, stocks, or commodities like oil and gold, inflation is taking a smallish but steady bite out of them every year. In fact, about every 20 years (as we saw with the grocery bill example), prices double due to inflation. Another way of putting this is, every 20 years, the value of our dollar is about half.

So if you invested $10,000 today, in 20 years it will only be worth about $5000 (in today’s money). If your original investment of $10,000 doubled over 20 years to $20,000″in fact it will then only be worth what that same $10,000 is worth today.

According to one of the most globally respected investors, Bill Gross of PIMCO Bonds, who manages two thirds of a trillion dollars: “Inflation poses a “stealth” threat to investors because it chips away at real savings and investment returns.”

So even if we are keeping our investment costs low (minimizing transactions costs, minimizing annual fees, and avoiding sales fees) we can still end up making little if any money by investing”if we aren’t beating the rate of inflation.

How to Beat Inflation

Interest on cash savings generally runs 1% to 3% a year, on average. (Today it’s slightly more at some online banks like Emigrant, ING and others, but don’t expect this to last even through 2007.) This is fine to protect our emergency fund, and it’s exactly what I do to park some cash. But in terms of inflation over time, we aren’t getting ahead. More often than not, interest on cash savings is less than inflation. This is one reason banks can afford to pay it!

Investing in bonds can earn us about 5% to 8% returns a year (on average) but after inflation this is really only 1.5% to 4.5% a year. We probably aren’t going to get rich this way, not even very, very slowly. High-earning bonds, i.e., returning 3% or 4% a year (after inflation) are great if we are retired and want that regular income to live on. Bonds are also good for medium-term investing needs (as part of a college savings fund, for example) because they fluctuate a lot less than stocks, and generally deliver on their promises, i.e., a set interest rate for a set time. But clearly at these earnings levels, bonds are not the best way to build up assets over the long term.

To really earn wealth over the long term, the stock market is where we need to be: the historical average in the U.S. has been 10.4%. That high rate may or may not continue, but it’s the average so far.

So putting together all that we’ve discussed over these five Investing 101 articles, what might investing in low-cost, no-load, diversified index mutual funds look like over the long term?

If we were to invest $10,000 in a fund like the S&P 500 index, paying 0.2% annual fees, and added $100 a month to it for 40 years, receiving 10.4% annual returns, what would theoretically happen to our investment with 3.43% annual inflation? What would it be worth in terms of today’s dollars? That’s 10.4% – 0.2% – 3.43% = 6.77% over 40 years. You can calculate it for yourself, or try investing different amounts if you like.

Initial investment: $10,000
5 years: $21,172
10 years: $36,830
20 years: $89,529
30 years: $193,044
40 years: $396,368

Well that looks pretty darn good, and it’s because we’re keeping our costs low, buying in small amounts of $100 a month, and holding over the long term. It’s not an amazing amount: we haven’t become millionaires. (Well, technically we have: in actual dollars we would have $1,259,227 after 40 years, but add in 40 years of inflation at 3.43% and it’s only worth $396,368 in today’s dollars).

But still, we have built up a nice little nest egg, which together with Social Security (if it still exists then) could provide a decent retirement for us. Or that $396,368 could buy a very nice house. Or an inheritance for loved ones. The point is, it’s very likely a lot more than you’d have if you didn’t invest $10,000 + $100 a month at all, or instead put that money into cash savings, or even bonds, while inflation ate away your returns.

But there’s one thing that could still really hamper our investment results, and that’s taxes. Stay tuned for the sixth and final installment of the Investing 101 Series: The Tax Man Cometh.