Inflation - Worse than you Think

I suggested last week that if you want to be wealthy you should find what the wealthy are doing and copy them. Another step in following the wealthy is to avoid those areas that diminish your wealth. Some call these the “holes in the bucket.” One of the biggest holes is created by taxes. Few people enjoy paying taxes and the wealthy go to great lengths to avoid them because they are a constant drain on wealth. One tax few people consider, is what Warren Buffet called the “inflation tax.” As I have discussed inflation with countless individuals, I have become convinced few realize how devastating its effects can be on some investments.
The average inflation rate over the last 100 years is slightly above 3%*, so let’s use that number for illustration purposes. What that means in real life is if you have $100 dollars today, you will need it to grow to $103 next year in order to be able to buy the exact same items. If it only grows to $102 then you technically have more dollars, but you can buy less with them, so you have lost wealth. Now here is where people get confused and where it gets really ugly from my point of view.
Suppose a conservative retiree averages a 3% annual rate of return.  A 3% inflation rate would eat up a full 100% of their gains. Imagine the outcry if the Federal government taxed 100% of all investment gains. Even if an investor obtained a 6% annual rate of return, the inflation tax in this hypothetical example would be 50% of total gains. Once you understand the high cost of inflation, you realize why wealthy investors work so hard to diminish its effects.
The tragedy of the “inflation tax” is that it unfairly punishes those on fixed incomes and conservative investors who are just trying to protect their nest egg. The less money you earn on your investments, the higher percent of your gains the inflation tax will claim. For many in retirement sitting on bank savings type accounts, the inflation tax consumes more than 100% of their gains each year. By comparison, the federal tax that we worry so much about can seem small.
Inflation should be right there with death and taxes on the list of things you can’t avoid. Even worse, if you earn nothing you will pay no federal tax, but the inflation tax will take its share just the same. It can be the most regressive tax we face.
I mentioned last week that the wealthy invest for growth while the poor seek principle protection. Unfortunately, many guaranteed investments do not even earn as much as the current inflation rate. For those investors, the “inflation tax” over a long retirement can be particularly damaging, and possibly the worst tax they will pay. If you want to invest like the wealthy, do not make the mistake of diminishing in your mind the negative effects of inflation.