Inflation—it’s that sneaky force that slowly chips away at the value of your money. But how exactly does it affect your wealth, and what can you do to protect yourself? In this blog post, we’ll break down the essentials of inflation and its impact on your financial well-being, all based on insights from our recent Ask About Wealth podcast episode.
What Is Inflation?
At its core, inflation is the gradual increase in the prices of goods and services over time. This might sound abstract, but it has very real consequences for your wallet. For example, if inflation is at 3%, something that cost you €1 last year will now cost €1.03. That might not seem like much, but over time, these small increases can significantly reduce your purchasing power.
The Current State of Inflation in Ireland
To put things in context, from July 2023 to July 2024, Ireland experienced an average inflation rate of 5.4%. What does that mean for you? If your salary hasn’t increased in that time, you’re now able to buy 5.4% less with the same amount of money. It’s like taking a pay cut without actually losing any of your salary.
How Is Inflation Calculated?
In Ireland, the Central Statistics Office (CSO) is responsible for calculating inflation. They track the prices of over 600 different items, from groceries to petrol, and compare these prices year over year. This gives us the inflation rate—a number that reflects how much more (or less) expensive things have become.
Inflation’s Impact on Your Wealth
Here’s where things get serious. If inflation continues at 3% per year over the next five years, the value of your money will decrease by about 14%. Over ten years, that decrease grows to 36%. And in twenty years, you’re looking at a 45% erosion in the value of your wealth. Essentially, nearly half of your money’s value could be lost to inflation if it’s just sitting in a low-interest account.
This is why it’s crucial to consider the real return on your investments. If you’re earning 6% from your stocks but inflation is 3%, your real gain is only 3%. And for those holding cash, the story is even bleaker, as interest rates on deposits often don’t keep up with inflation.
The Role of Different Asset Classes
Different types of investments react differently to inflation. For instance, cash is the most vulnerable, as interest rates rarely keep pace with rising prices. Bonds can offer some protection, but they often only match inflation, not exceed it.
On the other hand, property has historically outperformed inflation. In Ireland, residential property prices have increased by 62% over the past decade, far outstripping inflation. Stocks also have a good track record of outpacing inflation, but they come with higher volatility, which can be a concern, especially if you’re relying on your investments for income.
Then there’s gold. Often touted as a hedge against inflation, gold performs well when inflation is high but tends to lag during periods of low inflation. Its value is driven by supply and demand, which can make it a more unpredictable asset.
The Bottom Line: Keep an Eye on Inflation
When it comes to building and preserving wealth, ignoring inflation is not an option. Whether you’re negotiating a salary increase or evaluating your investment returns, always consider the impact of inflation. For instance, if your investment is earning 10% but inflation is 3%, your real return is 7%. But if you’re paying taxes on that return, your net gain could be even lower.
Inflation doesn’t just affect your assets; it also impacts your income. If your salary stays the same while inflation rises, you’re effectively earning less in terms of purchasing power. Over a decade, this can result in a significant reduction in what your income can buy.
Strategies to Protect Your Wealth
So, what can you do to protect yourself? The key is to invest in assets that have a history of outpacing inflation, like stocks and property. At the same time, be cautious with cash holdings and consider the role of bonds and gold in your portfolio. And remember, your strategy should align with your stage of life—whether you’re accumulating wealth or relying on your investments for income.
Inflation is like an anchor that can drag down your financial progress if you’re not careful. By understanding how it works and planning accordingly, you can make informed decisions that help protect and grow your wealth over time.
This blog post not only captures the essence of the podcast episode but also transforms the content into a format that’s easy to digest and share online.