Business Basics: Inflation and the Importance of Investing

By: Eli Levi  |  September 20, 2021
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By Eli Levi

In order to invest successfully it is important to understand two concepts within the monetary system: inflation and compound interest. For one, if someone does not invest, they will inherently lose money because of inflation. Inflation is the rate at which everything in the economy increases in value. If everything in the economy is increasing in value, and the money a person has in the bank is not growing at the same rate, then that person’s money, while still being the same dollar amount, is decreasing in value relative to the rate of inflation. For example, one dollar one hundred years ago is equal to fifteen dollars of today’s money. 

The inflation rate is influenced by several factors, the main one being the Federal Reserve Bank (FED). The FED has certain controls on the American economy, in order to achieve their dual mandate. For instance, the second part of their dual mandate is to achieve on an annual basis a two percent inflation rate. The FED does not typically hit this rate exactly, but they are usually within a pretty close range. The value of money from 2000 to 2021 has gone down 58.5 percent. Therefore, if someone had left their money in the bank from 2000 to 2021 it would have lost more than half its value. This illustrates the negative impacts of inflation. 

Another value of investing is the benefits of compound interest. Compound interest is when someone’s money grows at a specific rate per year causing exponential growth. It is the same as inflation but in the opposite direction. Instead of someone’s money-losing value to inflation, they are putting their money to work, to make more money for them. The tried and true method for making money using the stock market is to invest in the American economy. 

The American economy on average grows by a rate of seven percent annually. The method that many people use to invest in the American economy is to put their money in an index fund. One example of an index fund is Vanguard Total Stock Market Index (VTI). VTI takes the money and invests it into every single public company in the United States stock market. This is a way of betting on the American economy growing, because as the economy grows so do the companies in that economy, and by extension, the money invested in VTI grows, because it is invested in the companies in the American economy. The American economy grows on average about seven percent annually over a twenty-year period. So if someone invests in VTI with a twenty-year time horizon, they will make on average seven percent a year.  By the end of twenty years, their investment would have almost quadrupled. 

The key to investing is the time spent in the market. Timing the market does not matter if investors have a long-term time horizon. For example, if someone invested on the eve of the Great Depression, October 23, 1929, the worst time in history to have invested, if investors had kept their money in the market for twenty years, they would have still made an average of six percent annually. That is the power of compounding interest.

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