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Money, and beliefs about money, are deeply engrained in each one of us, shaping part of our personalities.
Beliefs about money are fashioned from very early on in our lives through our experience, socioeconomic circumstances and education, to name but a few.Personal views on money range from frugality, as expressed by Benjamin Franklin’s “a penny saved is a penny earned”, to living the grand life, as expressed by Oscar Wilde: “Anyone who lives within their means suffers from a lack of imagination.”
It is important that we know where we are on this continuum between frugality and free spending and how that impacts our relationship with money.
However, while we have different views on money, there are some key concepts that can assist us in better understanding and protecting the value of money. To do so it is important to understand the biggest threat to the value of money and the best way to combat it.
Inflation is enemy #1
Inflation is the general increase in the prices of goods and services over time and it erodes the value of money as time passes. At an inflation rate of 6%, the buying power of your money will halve in 12 years – that means in 12 years’ time your R100 will only be able to buy goods worth R50 in today’s prices.
The impact of inflation is clearly illustrated by looking at the cost of fast food, for example, in 1983 compared with today (see infographic).
The power of inflation dates back centuries, with the collapse of the Spanish Empire in the 17th century, for example, being largely attributed to rising and uncontrolled inflation.
In extreme times, inflation can run completely out of control like it did in Hungary in 1941 where it reached 150 000% a day for some goods, and more than 1 000 000% in recent times in Venezuela and Zimbabwe.
The main challenge for us is that the price of goods and services rises at different rates of inflation.
As our lives evolve, our own inflation rates change and, soon enough, we are unable to afford our standard of living.
As you go from being a single graduate living in a small apartment to becoming a married parent with children and living in a house, your personal inflation rate can change dramatically.
Couple these personal changes with macro changes in the world (such as oil prices), your country (education, medical and food costs) and your own neighbourhood (municipal and security costs) and things can get out of control.
In South Africa we use the consumer price index, or CPI, to measure inflation. It currently sits at around 4% per year, yet electricity tariffs surged almost 12% and education expenses rose 7%.
Employers tend to use the CPI as a benchmark for increasing salaries, which results in employees losing buying power over time as their personal inflation rate is often higher than CPI.
This is possibly why Ronald Reagan described inflation as “violent as a mugger, as frightening as an armed robber, and as deadly as a hitman”.How then do we counter the effects of inflation on the value of our money?
Understand the power of compounding
Compounding is often referred to as the eighth wonder of the world and is one of the most important principles in growing the value of your money. Compounding is simply where your returns earn returns.
As an illustration, imagine you invest R100 000 and earn 10% interest (see table). After the first year your investment would grow to R110 000. Subsequently you will earn 10% interest on R110 000 and not only the R100 000 invested.
By the end of the tenth year your investment would have grown to R259 374 and you will continue to earn 10% on this amount. Because of compounding you will earn R25 937 in year ten compared with the R10 000 you earned at the end of the first year.
The power of compounding intensifies over time and a small difference in growth can make a huge difference in outcomes. A 1% increase in return results in a person having as much as 57% more money 50 years later.
While 50 years may appear to be a long and unreasonable time, consider that your first retirement contribution at the age of 25 may still be working for you at the age of 85.
The key to fighting the erosive effect of inflation on the value of your money is to invest where you can earn a higher return, and compound that growth over time.
While inflation rates will change as you move through various life stages, you need to ensure that you do not interfere with the compounding process.
Wynand Gouws is a certified financial planner and a wealth manager at Gradidge-Mahura Investments.
This article originally appeared in the 20 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
