PNC recently published their 2011 True Cost of Christmas Index [pdf]. The cost of the 12 days of Christmas is up 4.4% this year.
So true love is more expensive.
This is a fun way of highlighting an important principle of personal finance – you can lose money without really trying.
In fact, you don’t have to actually lose money to lose money!
The hidden tax
Money itself is essentially useless. It’s just a tool, a means of exchange for goods and services.
Your purchasing power is what matters. And if you stuffed all your money in your mattress in 2011, you would need to cut back just to break even.
You will still spend $25. But it will only buy you $24 of the same goods and services you’ve been used to purchasing.
Now, on the surface, that doesn’t look so bad. But take a family with a household budget of $50,000 a year.
They will have to cut $2,000 from their budget just to maintain the same standard of living!
In other words, inflation is a hidden tax. You don’t see it, but you sure do feel it.
Little by little, it eats away at your ability to buy the things you want and need. You feel poorer because you are.
So what can you do about it?
Cash is the best asset to have, but the worst asset to hold.
You need cash to survive. We all pay bills with cash – mostly in electronic form these days, but cash nonetheless.
However, cash loses its value day by day in an inflationary environment. So holding cash is the worst thing you can do.
It’s a delicate balance, but one that must be found to get the most you’re your money.
The difference between nominal and real returns
If inflation spikes up, interest rates will follow eventually. Here’s where a lot of people fall into a trap.
It may be especially tempting as an encore to the low current interest rates. What if CD rates jumped from 1% to 5%? Sounds great, right?
But it’s a losing proposition. Here’s why:
Let’s say you were able to find a one-year CD that pays 5%. You invest $10,000 so you’ll earn $500 ($10,000 x 5%) over the course of the year.
But you still need to pay taxes on this money. Assume your marginal tax rate is 25%. After taxes, you’ll only earn $375 ($500 income x 25% tax rate = $125, $500 income – $125 taxes = $375).
In other words, your nominal return is 3.75% ($375 ¸ $10,000).
If inflation is 4%, your real return is -0.25%. (3.75% – 4.00%). So you’re losing purchasing power even though your return seems high by today’s standards.
Granted, it’s better than stuffing it in your mattress. But you’re still losing money even though you’re trying not to.
Buy now, use later
One safe thing you can do to preserve your purchasing power is to buy ahead. Note that we said buy ahead, not just buy.
Buy things now that you would normally buy later. More specifically, when you see a great deal on an item you use regularly, stock up.
Hard assets generally trump financial assets
Financial assets often struggle in an inflationary environment. For example, traditional bonds tend to get destroyed because interest rates are rising, making the bonds less valuable.
Of course, now you can get Treasury Inflation Protected Securities (TIPS) which helps protect you.
Stocks may do alright if the company is able to pass along price increases to its customers.
Hard assets (e.g. real estate, commodities) have tended to perform well in inflationary times in the past. Of course, the past is no predictor of the future, as we always hear.
In addition, how long will it be before real estate market really starts to recover? Can gold, silver, and other commodities continue their meteoric rise?
You have to decide for yourself. Or get help.
We highly recommend working with a financial planner. More specifically – work with a professional who gets paid to advise you, not sell you investment products.
They’ll earn every penny you pay them!
The quest for more income
BIGG success is life on your own terms. It’s about taking control to design and build the life of your dreams – no matter what the economy is doing.
One way to do that is to start your own business. You can do it part-time.
The extra money you make will help you preserve your purchasing power. And if done right, it could be your first step to financial freedom. That’s BIGG success.
Image in this post from stock.xchng