Inflation, Compound Growth, and the Time Value of Money

January 13, 2018

I have $100 to give you. Do you want it now, or in four year’s time?

If you’re like most people, you’d rather have $100 now than wait to receive it in the future. You want the utility of that $100 now, for whatever purpose you choose - whether it’s to spend in the department store, save at the bank, or pay off your credit card. (Of course, if there was no such thing as inflation and no such thing as interest, and you didn’t actually need $100 right now, then maybe $100 in a four years time is equally fine. But let’s get back to the real world…)

Financial modelling techniques such as Discounted Cash Flow (DCF) and Internal Rate of Return (IRR) reflect the truth that $100 has more value now than in a year’s time, because we can put it to work for us.

Inflation Erodes Real Value

Let’s suppose that retail inflation (Consumer Price Index, CPI) is 5%. So a box of groceries that costs $100 today, will cost $105 in one year. Inflation will have eroded the purchasing power of your cash. And if inflation stays at 5%, then the following year those same groceries will cost $110.25 (i.e. $105 x 1.05); the year after, $115.76 (i.e. $110.25 x 1.05); by the end of the fourth year, those groceries will cost $121.55 (i.e. $115.76 x 1.05). In just four years the real ‘value’ of $100 has deteriorated by almost 20%!

Inflation is naturally compounding, and a relentless destroyer of the value of our savings. It’s all very well putting something away in the bank each month for retirement, but if the growth of my cash does not keep pace with inflation then I’m essentially losing money every year in real terms. Moreover, I’ll be sorely disappointed when the time comes to stop work and live off my pension fund. Unfortunately, it’s not viable strategy to rely on bank rates beating inflation.

As you can see from the table, on this particular date across the major economies only Brazil and China had interest rates higher than inflation, which maybe was good news for pensioners in those countries but hardly useful for the rest of us.

The erosion of cash value in real terms, year on year, can be scary. This is exactly the reason why savvy investors prefer do something other than leave it in the bank (unless it’s cash reserves that might be needed near-mid term).

Lets look at the numbers:

What the above table shows is this: if you save $100 in the bank at 1% p.a. interest, but long term inflation is 4% p.a., then in ten years time your cash will be worth 25 percent less in real terms, and in twenty years time will be worth 44 percent less.

If you are planning for retirement (or any medium- to long-term horizon investment), but you ignore ‘beating inflation’ as a benchmark, then your capital will be eroded as surely as water dripping out of a leaky bucket.

Put Compound Growth To Work For You

The good news is, if your investment strategy does beat inflation year on year, then you benefit from the same compounding effect. Over time the value of your savings will grow substantially in real terms. Because compounding growth is an exponential process, truly significant effects take time to appear. Starting to save early gives two advantages; firstly, it gives compound growth plenty of time to do it’s magic, and secondly, the longer the time horizon the more scope we have for an adventurous investment strategy in the early years.

If you want to get an idea how your savings can be multiplied (or indeed how the price of groceries will rise) over time at a certain growth rate, here is a simple table: Compound Growth/Inflation Table.

Save Now Or Later?

When it comes to saving, some people delay starting early - they want to leave it a few years. The problem is, you can’t make up for lost time when it comes to compound growth. Take a look at the table below - it represents two savers; the first starts saving aged 21 years, and saves $5000 per year for just ten years. The second starts saving aged 31 years, and saves $5000 per year for thirty years.