Here in the Midwest, it is a gorgeous Sunday afternoon, and I would completely understand if you have better things to do with your time than read this article, so I’ll boil it down for you in one sentence: If you want to smarter than almost anyone you encounter on the street, and more importantly, put yourself in the position to build wealth for the long haul by thinking in terms of purchasing power rather than superficial dollar amount changes.
Now for the five-minute version.
If you read Yahoo News headlines today (actually, right now), you will see an article titled “Bad News For Social Security.”
The article is generally a complaint that the cost-of-living adjustment for the upcoming year of Social Security checks is only 1.5%. The article includes the obligatory quotes from Social Security recipients that remember previously receiving 3% or even 4% cost-of-living increases. The problem with this logic is clearly explained in Irving Fisher’s work The Money Illusion, which teaches us to think in terms of purchasing power, rather than superficial, nominal dollars that can corrupt our thinking.
If inflation is 4% and your Social Security check goes up 4%, then you are in exactly the same position that you were in if inflation runs 1.5% and you receive a Social Security raise of 1.5%. Neither one makes you any richer or poorer. In fact, ironically, if we have deflation of 2% and your Social Security check stays the same over the course of the year, you are actually getting 2% richer because you can buy 2% more goods with the exact same amount of money than you could the previous year.
Most people aren’t trained to think like this because you have to get past “your lying eyes.” If inflation runs at 3.5% in a given area, it takes a mathematically oriented mind to realize that selling a home for $300,000 in January 2013 is the same thing as selling your home for $310,500 in January 2014. This is why astute business people seem to have an exorbitant interest in getting cash in hand today—they understand the time value of money and it is better to get money into your hands as quickly as possible, so it can start earnings dividends, rental income, and interest rather than slowly losing its purchasing power in the form of delayed cash that may or may not arrive later.
Now, part of the Social Secuity article criticizes the way that the government calculates cost-of-living adjustments—for instance, the declining costs of laptop computers are factored into the calculation, and that is not a good particularly applicable for the 62 and over crowd. That kind of criticism is fair game—if you argue that the true inflation rate is higher than the cost-of-living increase, then you are working on a sound foundation.
The moral of the story is to always be thinking in terms of purchasing power, purchasing power, purchasing. As Warren Buffett likes to joke—the point of investing is to set aside money today so that you can buy more cheeseburgers tomorrow. That’s a beautifully clear analogy because it points out that the purpose of investing is to be able to acquire more goods and services than you could currently acquire with the capital you possess. That’s is why I knock off a few percentage points when thinking about investments—when Campbell Soup was growing at 3.5-4.5% during the past 10 years, it wasn’t really growing it all because the prevailing inflation rate was in close proximity to Campbell Soup’s growth rate. Basically, it spend a decade treading water (which, given the difficulties presented in the past ten years, isn’t exactly the worst result in the world). But I much prefer having assets like Colgate-Palmolive on the household balance sheet, which achieves long-term earnings per share growth in the 9.5-10.5% range, often six or seven percentage points above the inflation. That’s the kind of stuff that increases your purchasing power, and truly makes you richer.
If inflation is truly 1.5%, then receiving a 1.5% increase does not harm you. If inflation was 4% in the mid-2000s, then getting a 4% increase then puts you in the same position as getting a 1.5% increase. If inflation runs at 10%, I guarantee you that we will see articles about Social Security recipients feeling richer because they received a 10% increase, but that figure becomes meaningless once you reconcile it with the inflation rate. Never forget to factor inflation into your calculations. Always make purchasing power increases your main investing goal. If you can remember those two things, you’ll be the smartest man or woman walking down the street, unless you happen to encounter a fellow reader 😉