7.1 Investment Basics - Montgomery Township School District



Investing7.1 Investment BasicsActivityRead the Article attached at the end of this worksheet before completing this activity.NameUnderstanding InflationFrom the previous resources, you’ve seen that saving money in a bank account that earns less in interest (ex: 0.75%) than the economy experiences inflation (avg: 3%) leaves you with less spending power in the future. If you save $500 in a savings account now, you’ll be able to buy LESS with it in 2025 than you could today. That’s what makes INVESTING an important part of your long-term financial health. Let’s explore inflation a little further using this Inflation Calculator from the Bureau of Labor Statistics:Suppose you’re heading off to college next year somewhere cold, and you want to purchase a North Face parka for$350.From each paycheck of your afterschool job, you’re able to save $45 toward the coat. You get paid twice a month. How many months will it take you to save enough money to buy your North Face jacket?Using this strategy, how will inflation impact your ability to buy the jacket?You’re thinking $350 is a lot of money for a high school student, and you understand that, due to inflation, that same jacket would have cost less than $350 in the past. Use the calculator to determine how much the same jacket, had it been available, would have cost the year you were born.How much cheaper was the coat the year you were born?You take your answer to question 4 to your parent and say, “Hey, why didn’t you think ahead and buy me this coat the year I was born??? Look at all the money we could have saved!” Aside from the fact that your parent had no way of knowing you’d want a North Face almost two decades later, your parent disagrees with your logic and says there wouldn’t have been any savings by buying the coat in your birth year. Why is your parent making this claim?Let’s say, instead of buying you the coat when you were born, your parent put money, equal to your answer in question 3, into a savings account that earned 1% interest. Would you be able to buy your coat today with those funds? Why or why not? You can use this compound interest calculator you need to.So, if your parent somehow knew, the day you were born, that you’d some day want a North Face parka for your first year of college, what would he or she have needed to do, financially, to have $350 for the coat today?You’re thinking a lot about inflation, and you think it might be a good idea to set aside the money to buy a fancy leather couch for your first home, which you’d like to purchase 10 years after you graduate from high school. Why does the inflation calculator not tell you what the inflation adjusted price will be 10 years from now?BONUS: The North Face is available across Canada, and in parts of Europe, Latin America, and Asia. Would the inflation calculator from the Bureau of Labor Statistics work to calculate the historical price of that same North Face jacket in other countries? Why or why not? Do some online research to support your answer.HOMERELATED SITESDEFINITIONSFEATURED CONTENTABOUT USFEEDBACKSITEMAPSUBSCRIBE Your P l a ce i n C ybe r Spa ce for Infl a t i on Da t aNUMERICAL INFLATION DATAINFLATION CHARTSINFLATION CALCULATORSINF. ADJUSTED PRICESCOST OF LIVINGBLOGSeptember 17, 2014 for the year ending August 2014 | See our Inflation Calculator at | Next Data ReYOU ARE HERE: HOME ? BLOG ? INFLATION ? THE IMPACT OF INFLATION ON SAVINGSThe Impact of Inflation on SavingsFEBRUARY 5, 2013 BY TIM MCMAHON — LEAVE A COMMENT$33.74Custom Bannerup to 50% offThe obvious impact of inflation on yoursavings is that the purchasing power is erroded. This means that if you stash $100 under the mattress today and inflation is 3% per year when you come back a year from now your $100 will buy 3% less stuff. Put another way you would need $103 to buy the same amount of goods a year later. When you extend this to 10 years you might think that it would mean that you would need $130 to buy the same amount of goods but because of the effects of compounding you would actually need $134.39. Youcan use the Retirement Planning Calculator to calculate the impact of inflation on your savings.As time goes on the impact of “only” 3% inflation compounds making it even worse. Even though he was intimately acquainted with workings of the atom bomb, Einstein called compound interest the most powerful force on earth.Unfortunately, compound inflation is just like compound interest working against you. When you look at the effects of 3% inflation on your savings over 25 years we find that prices will have more than doubled and you will need $209.38 to buy the same basket of goods that $100 would buy 25 years earlier.Inflation Causes UncertaintyBecause the value of your money is constantly changing, this makes planning for retirement especially difficult since it is like shooting at a moving target. Especially, since you don’t even know for sure what the annual inflation rate will be.Inflation- The Leaking BucketOver the long run since 1913 inflation has averaged more than 3% (3.24% ) so on average it has taken less than 22 years for prices to double. So as you are saving it is like trying to fill a bucket while 3% is leaking out. So therefore, you have to put it in faster than it leaks out.What About Interest on Your Savings?So far we have only looked at savings that were put under the mattress. What if you deposit them in the bank? Won’t that help? If the interest rate is equal to the inflation rate then it would be like having a small faucet pouring water back into your bucket at exactly the rate it was leaking out.Unfortunately, current bank interest rates are at historically low levels, so there is only a drip going into your bank bucket from interest and so the level in that bucket has been declining almost as fast as the money under the mattress.Depending on what you invest in, some investments may do better or worse compared to inflation. Commodities like gold are often considered an inflation hedge and over extremely long periods gold and silver do retain their purchasing power. But often during the short run distortions can occur and cause their value to become over or under-priced. See Is Gold an Inflation Hedge? Over the last 15 years inflation has been relatively low and gold and silver have outperformed the effects of inflation. But that may not always be the case. The major disadvantage of commodities is that they do not provide a current income flow and so you are entirely dependent on appreciation keeping up with inflation.Real estate is another commodity that has been thought to do well at keeping up with inflation which was true for many years until the market became overheated and real estate values plunged. So like everything buying at the right price point is still important. Like gold if you own your own home it is not producing income (although it may be saving you rent) but investment properties can provide some protection against inflation and income at the same time.What about stocks?Once again the price of companies should theoretically grow so that the company retains its value against inflation. But when you invest in stocks other variables are introduced including stock speculation (boom and bust), the ability of the company’s management to deal with change, changing market tastes for the company’s products etc.Quite often stocks will outperform inflation allowing your investment to maintain its value against inflation but it is still possible that you will get in at the top and lose money over the short term or that any particular company will under-perform the overall market. Some stocks pay dividends in addition to the possibility for stock price growth. Stock dividends would act much like the interest helping to fill your bucket, while theoretically the stock price itself should keep up with inflation.What about Bonds?Bonds are debt obligations similar to putting your money in a bank. You are only guaranteed to get back a fixed number of dollars at the end of the life of the bond. Historically, bonds are considered to do poorly during times of high inflation because of this. In times of moderate inflation if the “coupon rate” i.e. the interest rate the bond is paying is high enough it can counteract the effects of inflation.What about Inflation Indexed Bonds?Inflation indexed bonds are supposed to be designed to take inflation into consideration and compensate the bond owner for the effects of inflation. See How Have Inflation Indexed Bonds Really Performed? for more information.Other FactorsOne of the other factors that can affect the real return you experience after taking into consideration the effects of inflation is the effect of taxes. In the first scenario if you had put the money under the mattress taxes would have no effect. The $100 was after tax income and because there was no additional income, taxes would not be a factor. In the bank scenario taxes would be minimal since interest rates are currently so small the money would haveearned very little and so there wouldn’t be much tax due. ................
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