Saturday, July 17, 2010

The Power of Time

"This thing all things devours:
Birds, beasts, trees, flowers;
Gnaws iron, bites steel;
Grinds hard stones to meal;
Slays king, ruins town,

And beats high mountain down."

-The Hobbit, J.R.R. Tolkien

My father is always talking about the good old days when you could go to the movies and pay a quarter for a double feature, newsreel, cartoon, and a cellphone-free environment. I am always quick to remind him that in the good old days, salaries were a fraction of what they are today, so that quarter was quite a big expenditure. He just mumbles something about kids today and walks away.  The main point here is that time has a crazy effect on money.  It devours it and beats it down so it becomes worth less and less as the years go by.

Imagine my father as a youngster heading to the movies with his quarter, happy as can be because he is going to watch two movies and a cartoon (I'm sure he could do without the newsreel but at least it doesn't cost extra). Now imagine that Doc Brown pulls up in his DeLorean and takes my dad into the future with his quarter.

Fast forward fifty years. Now my dear old dad with his quarter is sorely disappointed because not only is he at least ten dollars short at the box office, his quarter won't even buy him a pack of gum at the concession stand. What is the moral of the story (besides not hitchng rides from men in DeLorean's)? The quarter is the same as it was fifty years ago, but it buys a heck of a lot less!

Economists have a fancy word for this concept: inflation. Inflation is the eroding of the value of money over time. It is the reason why prices always seem to keep going up and up and why a dollar just doesn't buy what it used to. On the flip side, usually people's wages tend to go up in time, so that even though prices are going up, your income is going up to keep pace. How about the wealth that you've accumulated?

If you keep all of your money in the proverbial mattress, your money is eroding with every passing day. Here in the United States, the average annual inflation rate over the past century is about 3.5%. That means that, on average, prices rose about 3.5% each year. That might not sound like much, but that 3.5% increase adds up over time.

Products that cost $100 today are going to cost $103.50 next year.
Products that cost $100 today are going to cost $141.06 in 10 years.
Products that cost $100 today are going to cost $198.98 in 20 years.

You can see that at a relatively low rate of inflation of 3.5% will cause prices to almost double every 20 years. Fall asleep for 20 years and that $100 bill in your pocket is going to be worth half when you wake up!

The math for calculating the effect of inflation is straightforward:

i = annual rate of inflation

If something costs X today, it will cost X times (1 + i) next year.
If something costs X today, it will cost X times (1 + i) times (1 + i) in 2 two years.

In N years, the math looks like that:

Price in N years = Price Today x (1 + i)N

You can see how a little bit of inflation can erode the value of your money quite quickly. The key lesson here is to make sure that your bank account grows at least as fast as inflation. Otherwise, your dollars are going to keep getting less and less valuable.

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