How Inflation Erodes Wealth & What to Do About It

I don't like to be the bearer of bad news but it is crucial for investors to truly understand why inflation is so detrimental to wealth creation.

By having this sobering insight, we can admit to ourselves that we are not as rich as we thought. In turn, this can help us to ramp up our efforts in building wealth through the powerful discipline of spending less, earning more and investing the difference responsibly.

I believe that inflation is probably the investor’s worst enemy and I will illustrate why.

Let's imagine two scenarios:

• Scenario 1: There is zero inflation and a saver can get 5% interest on their cash.
• Scenario 2: A saver can still get 5% interest but there is also 5% inflation.?

Now imagine that in the first scenario, the government introduces a 100% tax on interest. Sounds pretty awful, right?

Well this draconian policy would have exactly the same effect as the 5% inflation in Scenario 2! In both scenarios the interest is entirely eaten up by either tax or inflation.

The above example, which I stole from Warren Buffett, helps to show just how sneaky inflation is. A 100% tax on interest is obviously insane. But a 5% inflation rate? Doesn't sound too crazy.

While the financial impact of both scenarios is identical, there is still a crucial difference: Emotion and perception. The saver in the first scenario will know they've been robbed. However the investor in the second scenario will look at their 5% gain and feel richer! What a stark contrast?

This is why it is so important to be reminded of the impact of inflation because everybody forgets (myself included).

So what can we do about it?

I'm afraid there is no easy solution. The bottom line is to work harder, spend less, invest the difference responsibly and repeat this noble habit year after year with a lot of patience.

The good news is that there are very strong deflationary forces at play. By this I am mainly referring to the advancement of technology and its exponential trend of increasing efficiency and reducing costs.

It is very easy to underestimate how powerful it is that today's technology is being used to create tomorrow's technology and so on. The speed of this progress, as we have recently seen with AI, might be scary on a societal level. But when it comes to long term wealth creation, being invested in the global stock market over the decades is ultimately the best way to hedge against inflation and capture financial benefits of humankind's advancement.

If there is anything practical to get from this article, it is to review your spending patterns. We all get addicted to spending money and need to reign it in from time to time.