Fixed income gets eaten up by inflation. If we don't invest our $1 to be able to buy $3 McChickens, what are we even doing?
Since 1802, the average rate of inflation in the US has been about 1.4%. Now, for the first 170 years or so, the US operated on the gold standard. This meant that every dollar was actually backed by gold. However, post-Nixon's decision to abandon the gold standard, we've seen inflation rates average around 4% annually, occasionally spiking to as high as 9%.
Initially, I viewed inflation as a negative force impacting our finances and the broader economy. But lately, I’m taking on the attitude of “hey, these are not my rules but I’ll play by them.”
Inflation has a way of diminishing the value of fixed incomes and investments. Think of it as the opposite effect of compounding interest. Take bonds, for example. Buying a bond is akin to lending money to the government or a company. Treasury bonds are popular because they're backed by the US government, which theoretically means they're low-risk since the government can always print more money.
However, the biggest and most dangerous risk is lurking on the surface like a saltwater croc. Inflationary risk. It's a consistent threat, silently eroding the value of money. I believe it’s the most dangerous form of risk because it’s inevitable. As the government increases the money supply, what seems like an increase in wealth leads to a decrease in purchasing power. So, when I invest $1000 in a bond, the annual returns lose value each year due to inflation.
I like to compare dollars to McChickens. Imagine a decade ago, setting aside a dollar for a McChicken on a rainy day. Fast forward to today, and I can’t get one in CA for under three bucks. That saved dollar now buys less than half a McChicken.
Now, compare this to investing $1000 in the general stock market, which could yield an average return of 7.2% per year. Accounting for inflation, my purchasing power could increase by about 3.3% annually. That's a better outcome in terms of maintaining and growing buying power.
Moreover, understanding which businesses to invest in, and using financial instruments like derivatives, can further increase cash flows. Just like Apple or Microsoft 30 years ago, there are opportunities available right now that will yield 1000s of percent returns over the next 30 years.
I’d rather own a piece of McDonald’s than lend them money given that they use their borrowed money to build out their infrastructure and sell $3 mcchickens to the world.
Another example of how often the "least" risky choices taught to us by others are some of the riskiest.
-Tanner
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