Inflation can make you rich or poor – are you on the wrong side?
Most people have been conditioned to only look at ROI (Return On Investment) when making decisions on investment choices. However, ROI is only one of the factors that can impact the performance of an investment. One of the more powerful forces is the force of inflation. Inflation has the power to help some types of investment decisions and hurt others and is one of the primary reasons why 80 percent of Americans feel like they aren’t prepared for retirement.
Most people know that the value of money is not fixed. The Federal Reserve and the banks are constantly creating money and consequently the value of money is continually decreasing. If you took $100 and put it in the bank earning 1% interest for 1 year and then took the $101 out 1 year later if the inflation rate was 3% you would lose 2%. i.e. if you bought a pair of shoes for $100 the same pair of shoes 1 year later would cost $103. We commonly refer to this as the purchasing power of money.
What most people don’t think about is the impact inflation has on investments.
|Asset||Inflation Effect||Additional Information|
|Real-Estate||Tracks Inflation||A MORTGAGE makes you rich.|
|Gold||Tracks Inflation||Relative Currency value also affects the price.|
|Stocks||Reduces Returns||Growth figures can be misleading|
|Mutual Funds||Reduces Returns||High fees compound the effect|
|Bonds||Investment Value Decreases||Increased in inflation drops the value|
|Lending||Investment Value Decreases||Loan principal value does not change|
In order to keep up with inflation and keep the purchasing power of money your investment needs to make a higher return than inflation to counteract the tax penalty. The key challenge is even if an investment goes up in price and tracks inflation you have to pay taxes on the gains. For example, if you bought an investment that tracked inflation and the price went up by $100, then you sold it, you would have to pay capital gains on the $100. This means that you lost ground, because you would lose 15% of the gain due to the long term capital gains tax.
The Long Term Debt Effect
One of the few ways to turn inflation from a negative to a positive is to use long term debt.
How does this work? The loan balance stays constant and the asset price goes up. This means that if you bought a house for $200K, with a $100k mortgage. When inflation increases the value 20% the value of the asset goes up by 20% ($40k) but the value of the debt stays constant (100k), resulting in a 40% return helping you beat inflation. Despite capital gains tax you are still ahead of the game.
Before – $100k mortgage $100k debt : After $100K debt, $140k equity = 40% gain with 20% inflation growth.
Without leverage the $100k increasing with 20% inflation would only generate $20k resulting in less purchasing power after tax.
Using debt to beat inflation works best when you have an asset that has an income stream that can be used to pay for the debt, such as a rental property or a business.
The force of inflation, if harnessed the right way, provides one of the most reliable and effective paths to financial freedom.