23 May 2021

---

Inflation: what it is and why it is important

Author: Luigi Campopiano

---

Compound interest is significant to succeed in investing. It is also essential to understand what factors damage our money and our returns. Investing in stock markets can be scary because people think they can lose all the money, and so, to protect their savings, they leave them in their bank accounts. This is an error for two reasons: we lose against inflation, and compound interest is not working.

But what is inflation? And why is it so important?

Inflation is a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money (a loss of real value in the medium of exchange and unit of account within the economy): to understand better, $1 in 1913 now worth less than 5 cents. Leave money in a bank account is harmful to our wealth.

According to the economist Milton Friedman, “inflation is a form of taxation which can be imposed without legislation.” The notion of inflation is so important because it is invisible: no one will tell you the inflation level when you subscribe to some investment product. To be a good investor, we need to keep an eye on actual returns: our returns minus inflation. For example, if we are earning 1,5% on a bank account and inflation is 2%, our real return will be -0,5% (at the end of the year, our savings will have a 0,5% loss).

The word “deposit account” is one of the most badly used in finance because our savings are not deposited, but the banks reinvest them at higher interest rates than those we receive. A deposit account gives us a sense of safety, but many banks invest our savings in riskier assets: for this reason, many banks went bankrupt.