2. Inflation and real value
Inflation means a rise in the general level of prices of goods and services in an economy over a period of time. In other word, it indicates a decline in the real value of money.
For example, let's say eggs cost $2 per dozen today. A personal with $10,000 could buy 5000 dozens of eggs. After 10 years, the egg's price become $20. The same $10,000 could only buy 500 dozen's of eggs. Therefore, the real value of the money is only 1/10 of what it was.
Unfortunately, just like interests, inflation also compounds. Therefore, at an annual rate of i, the real value of the money over n years would decrease by
(1+i)^n
For example, at a 3% inflation rate, over 40 years, the ral value of the money would decline
(1+3%)^40 = 3.2620
Giving back to our original example with compound interest. Our impressive $452,592.56 asset would be worth
$452,592.56 / (1+3%)^40 = $452,592.56 / 3.2620 = $138,745.34
in today's dollar.
Therefore, one should never be impressed by the numbers a financial advisor throws out, since it's the purchase power that is important. Just like compound interests can quickly grow our asset, compound inflation can work against us to shrink our purchase power. This is especially important in retirement calculation due the long time frame.
Inflation means a rise in the general level of prices of goods and services in an economy over a period of time. In other word, it indicates a decline in the real value of money.
For example, let's say eggs cost $2 per dozen today. A personal with $10,000 could buy 5000 dozens of eggs. After 10 years, the egg's price become $20. The same $10,000 could only buy 500 dozen's of eggs. Therefore, the real value of the money is only 1/10 of what it was.
Unfortunately, just like interests, inflation also compounds. Therefore, at an annual rate of i, the real value of the money over n years would decrease by
(1+i)^n
For example, at a 3% inflation rate, over 40 years, the ral value of the money would decline
(1+3%)^40 = 3.2620
Giving back to our original example with compound interest. Our impressive $452,592.56 asset would be worth
$452,592.56 / (1+3%)^40 = $452,592.56 / 3.2620 = $138,745.34
in today's dollar.
Therefore, one should never be impressed by the numbers a financial advisor throws out, since it's the purchase power that is important. Just like compound interests can quickly grow our asset, compound inflation can work against us to shrink our purchase power. This is especially important in retirement calculation due the long time frame.