05/15/2014 05:02 pm ET Updated Jul 15, 2014

Don't Look Now But Something's Eating Your Money

In 2004, the president of Haiti, Jean-Bertrand Aristide, abruptly fled the country after a coup d'état. Hours after he left, a crowd of looters broke into his abandoned mansion in the capital, Port-au-Prince, and began ransacking the property, looking for furniture, jewels, or other valuables. They weren't disappointed. One group of intrepid thieves found a safe in a basement and battered it with sledgehammers until it broke open.

Inside they found a heap of hundred dollar bills (American currency) held together with dissolving rubber bands, totaling about $350,000. However, the money had been stored in the safe for so long that it had partially decayed; some bills were permanently stuck together, while others had crumbled into dust. Nobody knew why the money was there or how long it had been languishing in the dank interior of that safe.

In any case, anyone can see that this is not a sound investment strategy: leaving your money at home leaves it vulnerable to theft and physical damage. But many people commit slightly more subtle errors when managing money. Stashing your money in a savings account at your bank protects your money from physical damage and gives you some peace of mind. But many of us forget that money doesn't just decay physically--it also loses that abstract quality called value. That's because there's an insidious force that gradually erodes the value of you money. That force is known as inflation.

Inflation, as you remember from Econ 101, is a rise in average prices over time, which conversely, can be viewed as a decline in the value of your money. For the economically naïve, inflation seems like a mere nuisance, if they bother to think about it all. For one thing, inflation makes budgeting difficult. For instance, will gas cost $3.90 this month or $4.00? How about next month? Additionally, we face the problem of wages not rising fast enough to keep pace with inflation. Many workers get annual raises adjusted for inflation, but for some there's a lag time between the rise in costs and the rise in wages.

Inflation, however, damages our finances in more subtle ways. It especially harms retired workers, who live on social security and money accumulated during their working years. In a more roundabout way, it penalizes consumers for saving (as opposed to investing) and rewards them for spending, since in times of high inflation, shoppers feel motivated to buy consumer goods before they increase in price, because the longer you wait to buy, the higher prices will climb.

The 20th and 21st centuries abound with cases of severe inflation--called hyperinflation--which sometimes led to strange consumer behavior. For instance, Bolivia experienced a bout of hyperinflation in 1984-1985, which caused prices to double approximately every twenty days. As a result, when Bolivians received their paychecks, they rushed to the store to spend the money before it lost any more value. After they had stockpiled as many groceries or clothes as they could use, shoppers often raced to electronics stores and bought televisions or stereo equipment that could be resold later. Unlike Bolivia's constantly depreciating currency, the Boliviano, the electronics equipment retained its value.

In that kind of environment, why would you bother to put money in a bank account, since that money would lose half its purchasing in less than a month? Can you imagine trying to save for retirement under those conditions? Unfortunately, the Bolivian hyperinflation was not an isolated incident. Similar episodes of runaway inflation have broken out in dozens of third world countries with (previously?) corrupt or incompetent governments, such as Nicaragua, Zaire, Bulgaria, Brazil, etc. The list goes on and on. If history is any guide, we can be sure it will happen again somewhere else.

(Image source: Wikimedia CommonsUser: "Kimsaka" License: Creative Commons Attribution-Share Alike 3.0 Unported)

Fortunately, the United States has not experienced hyperinflation in the past hundred years and is unlikely to in the future (knock on wood!). According to the Pacific Investment Management Company (PIMCO), the US inflation rate has averaged roughly 3.9 percent since 1944. Inflation ran amok for a while during the Carter administration, hitting 13.5 percent in 1980, but that was atypical. So, we can realistically expect prices to rise at something like 3.9 percent per year, barring an unforeseen economic catastrophe. A 3.9 percent increase in prices doesn't look like much at first glance, but that small amount can take a big bite out of your savings in the long run.

Let's consider a concrete example. I bought a Big Mac hamburger at McDonald's a few days ago for $4.19, not including tax--that price will vary depending on what part of the country you live in. If you use the inflation calculator at the Bureau of Labor Statistics website, you'll find that twenty years ago, that burger would have cost around $2.63 in 1994 dollars. If you go back another ten years, that Big Mac would have cost around $1.84 in 1984 dollars. (Of course, those aren't exact figures, since the prices of all items in the economy don't all rise at the same rate, but you get the idea.) Just as importantly, your wages have (hopefully) risen as well over that time period.

The main point is this: imagine if you had begun saving for retirement in 1984, but hadn't accounted for inflation. You would be effectively trying to meet living expenses at today's prices with a salary earned in 1984. Putting that money in a savings account wouldn't have helped much, since the average interest paid by most banks is well under 1 percent. At that puny interest rate, you would have to wait roughly 70 years for your money to double, meaning that inflation would have rapidly wiped out the value of your interest earnings. As you can see, dumping your money in a savings account isn't going to protect your wealth from the ravages of inflation. So what should you do?

This is where investing comes in: specifically, investing in a blended portfolio of stocks and bonds, and maybe even real estate or commodities. The historical rates of return for well diversified portfolios have on average managed to beat inflation. This is why, contrary to what a lot of younger people think, investing is not just a game for middle-aged rich people: instead, it's a way to protect your money from inflation, the hungry wolf chomping at your finances. Of course, these gains come with the risk of market crashes like the one we saw in 2008. Yet on the other hand, by opting out of the market, you face the guarantee that inflation will whittle away your savings year by year.

If you choose not to invest, then you need to have some other plan in place to protect your savings. Otherwise, you might as well lock your money in a dank safe and let it decompose.

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