This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
When the conversation turns to investing, someone always offers the sage wisdom that you should “buy low and sell high.” That sounds easy enough, but trying to put that into practice gives rise to thousands of other questions. What, precisely, should I buy low and sell high? How do I tell what is “low?” When does it qualify as “high?” This book takes the basic idea for granted and tries not to insult your intelligence. If you could just go out and buy stuff low and sell it high, then you wouldn’t be reading this book. We will specify our first rule of investing as the one laid out by famed investor Warren Buffett: Rule 1: Never lose money. Rule 2: See rule number 1. That too sounds easy, yet it is the reason that many people fear the market and fail to invest for their golden years, which in turn will not be so golden after all.
There is a lot of age-old wisdom out there as to what is the best way to invest. Most of this sage advice (that’s usually wrong) revolves around two major concerns. (Capital is just another word for money). The first is capital appreciation—that’s just a fancy way of saying you want to see your money grow. The second (and most emotional) is the idea of capital preservation: We want to make sure we don’t lose money.
What makes all this seem hard to many people is that risk tends to be rewarded in the investment world. This is true in many cases; some investments, however, are about the same as putting your money down on the horse races. Some are nearly entirely safe (U.S. Government Bonds), but there will be very little capital appreciation.
Inflation: Why We Must Invest
Have you ever noticed that with the exception of consumer electronics and gasoline, everything gets more expensive every time you look around? It is not your imagination at work. Most of the time, things really are getting more expensive. Economists and investors call this inflation. An important thing to realize about money is its purpose. Sometimes, we get so enamored with making money that it takes on intrinsic value; money is good because money is good.
If you really think about it, money is good because we can buy stuff with it (and pay for services). If you couldn’t buy things with it, nobody would work or invest. We would not bother. After the civil war, people didn’t want to own confederate money. Since the Confederacy didn’t exist anymore, the money became worthless. Economists might explain the particulars differently, but for the average person with a fist full of Confederate dollars, the result was that stuff couldn’t be bought with it anymore.
Inflation can grow, shrink (a rare condition called deflation), or stay the same. Nevertheless, most of the time it moves along at a relatively predictable pace of around 2% to 3% per year. A 3% inflation rate means that if a bottle of soda costs you $1.00 this year, the same bottle of soda will cost you $1.03 the next year. The year after that, it will cost you $1.06 (if the inflation rate remains the same). One of the insidious things about inflation is that it happens slowly over a protracted period. Rarely is inflation so high that we actually notice it in our everyday lives.
You are unlikely to notice a three-cent increase in the cost of a bottle of soda, and if you do, you are not likely to care. We fail to realize that every good and service that we buy is subject to the same increase in costs. Another way to look at the problem is in terms of what a dollar will buy. We often refer to this as purchasing power. We are accustomed to thinking of the value of the dollar as a fixed quantity. A dollar is always worth a dollar. This thinking is a big mistake because we don’t really want dollars; we want the stuff that the dollar can buy us.
Looking at the value of money in terms of purchasing power allows us to “adjust for inflation” by subtracting the amount of purchasing power that we’ve lost from the amount of money that we have. Therefore, in our soda example above, our dollar in year two is only worth $0.97. This means several things regarding our finances. One necessary implication is that any year that you aren’t getting a raise, you are losing money. Let’s say you started a job making $40,000 per year ten years ago, which was pretty good back then. You are now making the equivalent of $28,000 when your salary is adjusted for inflation. You should be making $52,000 per year today just to keep from losing purchasing power due to inflation. That means your quality of life has not improved; you’ve just been treading water.
Some employer and social security recipients receive a cost of living adjustment (COLA) every year to keep the playing field level. Nobody wants his or her standard of living to decline every year, so we insist on this “raise.” If we do not get it, we can buy less stuff with each passing day. The amount that a broad basket of stuff goes up over a period may seem too simplistic to be a useful indicator of economic conditions, but that is precisely how it is done. The most common measure of inflation is the Consumer Price Index (CPI), which is a measure of how much the price of stuff has gone up over a given period.
The same lack of buying power affects businesses and public institutions as well. If you work for a public agency and you hear that the budget is “flat,” it means that no new money has been allocated for the coming year and the budget remains the same as last year. In such a case, the business or institution is actually losing about 3% every year. If budgets stay flat for a decade, then the actual purchasing power of the institution is only 70% of what it was a decade ago.
When legislatures fail to give universities more money each year, for example, there is a 3% budget deficit. Belts can only be tightened to a certain degree before services decline, buildings fall into disrepair, and the brain trust is depleted as the best-qualified professors move on to greener pastures. To keep the doors open and to keep providing the same level of “service” to students, tuition, and fees must increase. This translates to fewer tax dollars and more student loan dollars.
Last Modified: 07/11/2018
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