Something that is severely lacking in our education system is basic financial literacy. So what is inflation and how does it affect you?
What is Inflation?
For the average consumer, inflation means that goods and services are going to cost you more to get the same amount you used to get. Most people will instinctively consider this a bad thing, but the reality just isn’t that simple. The Federal Reserve actually tries to control for a 2% rate of inflation year over year. When examining the overall economy, this makes sense. If your money is losing purchasing power, that means you’re going to want to put it towards an investment that will make more back than you’re losing. For businesses, this can be expanding their operations, or putting money into the stock market. Conversely, if the currency deflates, that incentivizes business owners to hold onto their money, slowing growth in the overall economy. Because of the Fed’s tendency to promote inflation, you’ll want to practice investment strategies to help you hedge against this economic reality.
Don’t Get Caught Out, Be Prepared
If you’re like the majority of working-class Americans, you have very little savings, no investments, and the greatest portion of your wealth is in your property. And no, I don’t mean your house. You probably don’t have a house. What you do have is a car and your personal possessions. You probably have debt as well, I know I do. All of this adds up to mean that you’re incredibly ill-prepared to weather any economic shocks. And you are likely facing a lot of stress and strain from the current crisis. That’s okay, but it’s still important to work towards being prepared for any crisis that rears its ugly head.
6 Months of Savings
The first thing you should do is build up a sizeable amount of savings, this functions as an emergency fund in case you get laid off or lose your job, and should cover 3-6 months of any bills you might have. Shop around at different banks for the highest yield you can find, unfortunately, interest rates at banks are incredibly low, with the average being a measly .06%. If you have trouble saving up cash, a good strategy to start with is looking at your bank statements. Analyze each individual item, and start finding things to cut out. Look at similar purchases as a group as well and tally them up for a full total. Buying a sandwich at work for $5 dollars may not seem like much, but the $100+ dollar total can put things into perspective. Make your own lunch instead of buying it at work, and you’ll likely cut out half or more of your total lunchtime expenses. Do this with any other items you can cut out, or cut down on, and start putting it into your account instead.
Low Risk, Low Reward
Once you’ve started growing your savings account, you can move on to some real investments. One of the lowest risk investments you can make is purchasing a United States Treasury Bond. Although the major issue that comes with this investment strategy is the low rate of returns, returning only about 4-6% interest over their lifespan. Something many aren’t aware of is the ability of the holder to sell a bond before it reaches maturity. Via a brokerage firm, you can sell your bond on the open market, although the final price you’ll receive depends on several factors. Firstly, the amount of time until maturity is a major factor, as a bond that will continue to provide yields for 10 years is worth more than one that matures in a year. Secondly, the actual interest rate on the bond is another major factor, with bonds that provide a higher interest rate than the newly minted ones garnering a higher price on the market. For those worried about inflation, however, products known as TIPS, or Treasury Inflation-Protected Securities, might be more up your alley. These securities pay out the advertised interest rate but adjust your initial investment, or principal, to keep pace with inflation. This means that if you invest $100, and inflation stays at 2%, and the interest rate on your TIPS is 1%, instead of earning $1 dollar that year, you would earn $1.02, based on your principal being adjusted to $102 dollars.
The Goldilocks Zone
The average person probably doesn’t want to spend a lot of their time researching different investment products, analyzing rates of return, or underlying fundamentals of a business to determine the right stock pick. And there’s nothing wrong with that. Researching individual stocks and comparing them to other businesses in their industry is time-consuming and requires a lot of specialized knowledge. That’s where something like an ETF or a Mutual Fund comes in.
What Are ETF’s?
ETF’s, or Exchange Traded Funds, are a type of investment product that offers the holder access to a diversified portfolio without actually needing to buy a large number of individual stocks. The majority of ETFs on the market are index funds. This means that the capital invested in the firm is then invested according to an index, like the S&P 500, and attempts to recreate its performance. The fund then pays out dividends according to its overall returns to those who own a share of the ETF. There are also other types of ETFs, like those that track precious metals like gold, those that track currency, or funds that are actively managed. For actively managed funds, be wary of any fees that might be skimmed off the top, although these fees will be publicly available for you to see. A similar product, not sold on an exchange is a mutual fund.
What Are Mutual Funds?
Even if you don’t already know what a mutual fund is, you’re probably invested in one right now. If your employer has a retirement scheme you’ve been contributing to, it’s likely being invested into a Vanguard mutual fund. A mutual fund is a lot like an ETF, with the major difference being that it isn’t sold like a stock on any exchanges, but rather made as a direct investment with the company. This generally means that entrance into a mutual fund is going to cost more than an ETF, you’re looking at anywhere from $1,000-$10,000 for your initial investment. If you want to add money, later on, the minimum amount is going to vary based on the fund, but generally, they’ll let you add in any dollar amount after your first investment. Another offer you’ll want to take advantage of is compounding. What this means is that any dividends that would’ve otherwise gone to an account ready to be cashed out, will instead be automatically re-invested into the fund. This is important because the difference between a non-compounded account, and one with compounding can be staggering further down the line. With an initial investment of $10,000 dollars, at an interest rate of 5%, without compounding you would make $5,000 dollars after 10 years, with compounding, you would make $6,288 after 10 years. And that’s without any additions to your overall principle. Over time this can help lock in growth that you would of otherwise missed out on.
Max It Out: Your 401k and You
If your employer offers a 401k program, take advantage of it. And if they offer matching, max. it. out. For those with access to a traditional 401k, any money put away into this account will lower your income tax burden. This is because your money enters the account, and stays in the account before any taxation occurs. This means you’ll be able to invest more of your money upfront, with the 20-30% gaining interest until you finally take it out. When you do take it out, you’ll have to pay income tax on the money. A Roth 401k is the opposite, your money goes in already taxed, and when you finally take it out in retirement, it’s untaxable income.
What About IRA’s?
IRA’s, or Investment Retirement Accounts, are different from 401k’s in that you don’t need an employer to set one up. Like a 401k they have both a traditional and Roth version. Contributions to a traditional IRA can allow you to deduct a portion from your income taxes, and a Roth IRA allows you to put post-tax money into it. There is a third type of IRA, and that’s a rollover IRA, that allows you to “Rollover” money from other investment accounts. Imagine you had 3 different jobs that had retirement plans, and you put money into all of them, a rollover IRA would allow you to consolidate all of those accounts into a single account.