Welcome to Day #3 of Investing Bootcamp!
In Day #1, I shared with you the results of a financial literacy study where respondents had difficulty answering questions related to compound interest and inflation. A few days ago we covered compounding and today we will cover inflation.
The exact question from the financial literacy quiz was:
Imagine that the interest rate on your savings account was 1% per year, and the inflation rate was 2% per year. After one year, how much would you be able to buy with the money in this account?
A. More than today
B. An equal amount as today
C. Less than today
From the last question, we know that $100 at 1% is $101 (100 x .01). Cool—that part was easy.
So what is inflation, exactly?
I am 46 years old. That’s inflation.
Just kidding, LOL.
I am 46 years old, and I remember when a Hershey’s chocolate bar cost $0.25. Today, in 2015, the average price is $1.19. This new price is an increase of 476% in let’s say, just over 36 years. It could have been more or less in some years, but in 1978 a chocolate bar cost .25 and in 2017, it cost $1.19.
And this would be inflation.
How is inflation measured (i.e. the question we are attempting to answer tells us that inflation is 2% per year)?
It is based on a basket of goods that someone in the Government has decided is somewhat applicable to most of us. It changes every year based on trends (i.e. subscription to cable T.V. gets bumped; iPad makes its grand entrance!). It is also seasonally adjusted, to account for the fact that many of us spend much more on heating costs in the Winter. Stuff like that.
I am sure it is all quite scientific and that the mere existence of the CPI (did I mention that is what it’s called? The Consumer Price Index) keeps hundreds of civil servants employed picking and choosing all sorts of goods and services for the basket in Canada (i.e baby wipes, cereal, every book in the Twilight series—not making that up!).
But, as I am sure you can see, while the Consumer Price Index (CPI) measures the rate of inflation of a given time frame (i.e. one year), quite a few items in the basket of goods don’t completely apply to to me. (trust me, my days of needing baby wipes are long gone!)
So I am going to make my own. Because it’s my Bootcamp and I get to make those decision.
Here we go…the official (you read it here first!) Money Coach CPI:
All right. What can we glean from the above? Most things go up (lipstick, wine, food), but a few things go down (technology tends to get cheaper: think how flat screen T.V.s in 2017 are a fraction of what they were in 2006). And some things stay the same (at least for awhile).
Yes, you are right! Inflation—according to the Money Coach CPI, in 2017 is 1.68%.
Calculated by cost of goods in 2017 being $11.75 more than 2016 ($710.85 – $699.10 = $11.75).
And this increase of $11.75 is a 1.68% increase over the previous year ($11.75/$699.10 = 1.68%)
And with that, I think we have enough information to answer our question: Imagine that the interest rate on your savings account was 1% per year, and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
Let’s go back to our $100 question:
If we earn 1%, we have: $101 (100 x .01 = 101)
If inflation is 2%, a basket of goods that cost $100 today, will cost $102 next year.
We will have $101.
We will need $102.
Ah, crap. (The answer is C. We can buy less than we could today)
I don’t know about you, but I’m losing the kale!
1. A Primer On Compound Interest
2. Inflation; What the Heck?
3. Mutual Funds 101
4. Exchange Traded Fund (ETFs)
5. The Dreaded MER
6. Bonds? I’ll take one, thanks!
7. So you want to own stocks? Me too.
8. An Introduction to Asset Allocation
9. RRSP or TFSA?
10. Bonus: Dividends, your new BFF
11. Bootcamp…in Conclusion