Yesterday we talked about the nuclear power of compound interest, which can steadily grow our wealth if we find the right investment and financial management strategies. However, compound interest has an enemy, and that enemy is inflation. In a previous discussion, we mentioned that inflation is like slow poison that can severely damage our wealth over time. Today, we will explore how inflation eats away at our wealth and discuss ways to combat this enemy of compound interest.
Firstly, let us understand why there is inflation in the first place. This can be traced back to after World War II, when Western powers were invited by the US government to attend a meeting in the Bretton Woods resort in New Hampshire. The outcome of this meeting was the creation of a new international monetary system called the Bretton Woods system. What is the Bretton Woods system? Simply put, it pegged the US dollar to gold, and other countries' currencies were pegged to the US dollar. For example, one ounce of gold could be exchanged for $35, and dollars could be exchanged for other countries' currencies. The US dollar became the world's currency, and this system played a central role in the global economy.
However, this system inevitably brought about a problem. Unlike bricks, gold reserves are finite, but the world's economy continued to move forward. For example, if I planted 100 kilograms of potatoes this year and sold them for $100, and next year I had a tractor and could plant 500 kilograms of potatoes, the sales amount would increase to $500. Therefore, the limited gold reserves would affect the issuance of the US dollar, and a shortage of money would inevitably constrain global economic development. Therefore, in 1971, US President Nixon announced the cancellation of the US dollar's peg to gold, which meant that the US was no longer bound by gold and could freely print dollars. From then on, money could be created out of thin air.
You may wonder why your money has lost its value. During the period when gold and the US dollar were pegged, the world was almost moving at a constant speed, so there was no significant inflation. However, now that every country has a central bank that controls the amount of money issued, and our economy continues to grow, the demand for money continues to increase. Therefore, if the amount of money you have remains the same, but the amount of goods and services in the market has increased, the relative value of your money will decrease. This is why we need to earn more and more money just to maintain our current standard of living.
The Effects of Inflation on Our Wealth
Inflation affects different groups of people in different ways. Those who are retired and living off a fixed income may be most affected by inflation. For example, if you are living off a fixed pension and the rate of inflation is 3%, the amount of goods and services you can purchase with your pension will decrease by 3% each year. This means that the purchasing power of your money is reduced, and you may have to adjust your lifestyle or reduce your standard of living.
Even for those who are not yet retired, inflation still affects our wealth in different ways. For example, if you have $100,000 in a savings account with an interest rate of 2% and the rate of inflation is 3%, your real return is actually negative. This is because even though you are earning interest, the inflation rate is higher than your interest rate, which means the purchasing power of your money is decreasing over time.
On the other hand, if you invest in stocks or real estate, you may be able to outpace inflation and earn a positive return. For example, if you are investing in the stock market, you can invest in stocks of companies that have a history of increasing their dividends regularly. These companies are called dividend aristocrats and are considered a safe investment for long-term investors. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. Investing in such companies can provide a steady stream of income and can help to counter the effects of inflation.
Another way to protect your investments from inflation is by investing in real estate. Real estate can provide a hedge against inflation as the value of real estate tends to appreciate over time. Additionally, rental income from real estate can provide a steady source of income.
In conclusion, inflation can have a significant impact on your finances if you do not take the necessary steps to protect your investments. To counter the effects of inflation, it is important to invest in assets that have the potential to appreciate over time, such as stocks and real estate. Additionally, it is important to invest in assets that provide a steady stream of income, such as dividend aristocrats. By taking these steps, you can protect your investments from the effects of inflation and achieve long-term financial stability.
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