People are aware of inflation, since it is talked about all the time on the news and they see gasoline prices increasing astronomically and erratically. You may have heard someone talk about loss of purchasing power, but what does that mean?
As a quick review, when you invest or save money, and you pull it out later, it should be worth more. This is because it either pays interest (e.g., bank pass-book savings, money market account, certificate of deposit [CD], bond), or earns dividends (e.g., stocks), or appreciates in value (e.g., stock, real estate).
If you invested in a savings account, CD or money market account, you are typically going to earn 0 – 1.5% annually.
Inflation (increase in the cost of goods), on the other hand, averages about 3.5% over time. If the money you deposit in an interest earning account earns less than the rate of inflation, you won’t be able to buy the same amount of goods when you take your money out to buy something as you could have bought before you invested the money. You have lost what is called purchasing power.
If you buried the money in a coffee can in the back yard or hid it in your mattress, it would not appreciate in value at all. Each year you left it in the ground or in your mattress, it would actually go down in value an average of 3.5% per year, since you can’t buy the same amount of goods with it when you take it out as you could have bought with it when you buried it or hid it.
Some people are very risk averse, meaning they are afraid stocks or bonds may lose value. However, as you can now see, even by taking no risk, your money can go down in value if not invested wisely.