Updated: Nov 9, 2022
It’s not about how much you save that matters.
Purchasing power of U.S. dollar: Fred
Inflation for dummies
If you do not understand the basics of personal finance, you are likely costing yourself money. Every day your money sits in your savings account collecting dust is an opportunity wasted. This collection of dust in your account is fueled by inflation.
- What is inflation?
To understand why saving your money is such a bad idea, you must understand what inflation is. Inflation is when your purchasing power declines, meaning $1 buys you less as time goes by.
The purchasing power of the U.S. dollar is almost constantly in a downward spiral. If you save money, it simply decays in value over time. The most common way to determine inflation is the CPI (consumer price index).
- CPI (consumer price index)
CPI measures how the pricing of a basket of goods changes over time. The following goods are included in the CPI reading:
Medical care commodities
Medical care services
Education and communication
Services less energy services
- Types of inflation:
Demand-pull inflation: When the demand for goods is higher than production capacity. An example is the prices of computer chips skyrocketing because of the lack of supply.
Cost-push inflation: When production costs increase, such as labor and raw materials.
Built-in inflation: Prices rise on expectations of inflation in the future.
- It doesn’t matter how much you make
Even if you make $500,000 annually, it doesn’t mean you are being hit by inflation any less. Additionally, if you have bad spending habits, you can still end up broke regardless of how much you make.
Many professional athletes and lottery winners end up broke soon after they stop making money. A lack of financial education can cost you a lot of money.
- It doesn’t matter how much you save
If you put your money into a savings account, the value of that account will continually drop. There is a much better way to use your money to avoid getting hit by inflation.
You must learn how to put your money to work
The key to financial independence is how well you invest your money. Instead of saving money, you should invest it in assets that will put money in your pocket.
You should be investing most of your active income into passive income sources. Eventually, you can retire and live off your investments alone. Your assets can also be passed down to your family.
Where to invest your money:
- The risks of investing
Investing your money does not always mean you are guaranteed a return. You can even lose money if an investment goes wrong. Therefore, you must watch out for these risks:
No diversification — You may incur substantial losses if you put all your eggs in one basket. If you don’t want to take too much risk, diversify into multiple asset types.
Panic selling — It is normal for the financial markets to have bad years. However, it is not a loss until you sell. You must know how to hold your investments even when they are falling.
Investing too much — If you invest too much money, you may be forced to sell at a loss. If you need the money within ten years, it is not a good idea to invest it in any risky assets.
No investment plan — If you blindly buy into an investment without doing any research, you can end up getting burnt. Make sure you perform your due diligence before investing in anything.
- Investing in the stock market
The most reliable way to invest in the stock market is through ETFs and index funds. You can try to pick stocks on your own, but most investors fail to beat the passive stock indexes.
- Investing in real estate
You can invest in real estate both passively and actively. Purchasing rental homes and managing them is considered active while investing in REITs on the stock market is considered passive real estate investing.
- Investing with options
When most people think about options, they do not consider them investments. However, trading cash secured puts is a great way to invest in stocks. You get paid a premium for promising to buy shares of stock at a specific price.
During periods of high inflation, commodities like oil and natural gas rise. You can invest in oil and gas on the stock market to hedge your money against inflation.
Cryptocurrencies are an emerging asset class that is considered high risk. The two leading cryptos are Bitcoin and Ethereum. It is hard to say if cryptos will be widely adopted, but investing in at least a bit of crypto would be good.
Why investing is important
Investing your money is the only way to negate the effects of inflation on your money. You simply cannot save your way to riches since the dollar’s value drops too quickly.
- You must grow your money
Investing is important because it is the only way to grow your money without doing any active work. Active income is great, but when you invest your money, you grow it passively.
If you only have 24 hours a day, it is impossible to scale your active income when you hit a certain threshold. As an investor, you can scale your portfolio up to as much as you want.
Suppose you make 10% annually on a $100,000 account that is a return of $10,000. If you make 10% annually on a $1,000,000 portfolio, that is a return of $100,000. As your portfolio grows, your passive income will grow with it.
Inflation for Dummies | Bottom line
No matter how much you make or save, it will not replace bad money management skills. You must find ways to make your money work for you.
Once you start investing in assets, you will be generating passive income. When you own enough assets, you can rely solely on passive income and forget about your active income sources.
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