Principles of Finance: Unit 5, The Math of Future Value: Inflation

The math of future value: inflation.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:26

pattern it's followed the previous century well you're almost certain to

00:29

become a billionaire the only problem well at that point [money falling down]

00:32

you'll be a too old to really enjoy the dough and be a carton of milk will by [skeleton under a tomb stone]

00:37

then probably cost a million dollars so yeah the focus here is on the manner in

00:41

which inflation eats into investment returns and how quality of life changes [100 dollar bill getting inflated]

00:46

because of it all right here's you you're planning a

00:49

life spouse homes picket fence 2.3 kids a dog put all your money into five

00:55

percent yielding bonds which yield like three percent after-tax in a world where

01:00

inflation is 2% and well it'll take you some 72 ish years to double your initial [writing on white board]

01:06

year's investment painfully slow and most people think about investment [tomb stone]

01:10

returns when they do think of them in an inflation blind way that is they were [man covers eyes with paper bill]

01:15

just absolute return numbers so they didn't reflect the buying power of those [writing on white board]

01:20

dollars down there in the future when you sold your stocks and then you know

01:24

bought stuff in order to get ahead in the world where your money actually

01:28

works for you rather than just being a placeholder store of wealth or savings [coin turning on table]

01:33

well you have to beat inflation handily and there's a headwind that you face

01:37

when you invest your money world conditions that is the world there's a [world map]

01:41

highly indebted place country a owes a trill country B II owes 500 bill the

01:48

u.s. owes some real 8 9 10 trillion and Counting depending on how you count it

01:53

and most of that debt is payable in the country's own sovereign currency so that [european money falling]

01:58

the countries are highly incentivized to let inflation run wild with lots of

02:03

change in what a dollar buys ie that dollar buys less and less over time and

02:08

then making it easier for the indebted to pay off their debt yeah well then

02:13

inflation is the friend of the indebted nation the

02:16

easy way to assuage the pain of carrying all that debt is to encourage active [boxing gloves punching inflation]

02:20

inflation continuously over long periods of time so you know the kindly loving

02:26

people here at shmoop are betting that long sustained inflation and well

02:30

happens so let's focus on just the numbers behind that inflation well an [writing on white board]

02:33

investment compounds it say 10 percent let's ignore taxes and fees for now but

02:38

10 percent is about the historic norm over a century with dividends reinvested

02:42

like you got seven and a half percent return on your stock two and a half

02:46

percent dividend and yet we're ignoring taxes so that adds up to about 10

02:50

percent a year alright so Wayback Machine time go back

02:53

to the 70s post the Vietnam War wallah with the government spending loads on

02:58

weapons tech and telecom prices are skyrocketing inflation is a 12% like it

03:04

was for a few minutes in the early 70s well in this case in this scenario [president shaking Elvis' hand]

03:07

you've actually lost 2% a year in buying power right your investments are growing

03:13

at 10% and yeah we're ignoring taxes again again here we're ignoring them [writing on white board]

03:17

yeah and with inflation at 12% well yeah you got 10 - well there you got negative

03:22

2% buying power meaning the world's getting 2% more expensive to live in

03:27

each year that's each year compounded and ouch at this rate in a decade you'll

03:33

have lost a tire off your car or about a quarter of your value even though your [car falls apart]

03:38

investment will have way more than doubled so this situation is an anomaly

03:42

that kind of crazy inflation hasn't really happened in the US but in other

03:46

countries Brazil Greece hi Russia we're looking at you well it has in the US the [world map]

03:51

more common pattern has been that inflation regresses to its mean rate of [statue of liberty]

03:55

about 2 or 3 percent a year and the 10% a year you're returning from index fund

04:00

investments in the S&P 500 is a good solid net return outpacing inflation by

04:06

7% or so to produce a real or adjusted return by.ya 7% that's your real return

04:12

so a billionaire in 97 years is really what you Nair today well if inflation

04:17

averages 3% a year for 97 years well then you have to take that future [writing on white board]

04:22

billion dollars and discount it back massively like one bill

04:26

and divided by the quantity one plus point zero three to the 97th power so

04:32

what is a billion divided by about a seventeen point six or so well it's

04:36

fifty seven million dollars today yep you read that right with three percent

04:40

inflation for ninety seven years a billion bucks in ninety seven years will

04:44

have the buying power or feel like fifty seven million dollars feels today that

04:49

is you could afford a nice but not crazy showy home in Silicon Valley yeah that's [nice picture of a home]

04:53

about fifteen twenty million bucks you can afford a nice cabin home in Jackson

04:57

Hole yeah that's about six million and then you have to live on the rest so you

05:01

can afford make a small jet but they're definitely not the g6 amazingly a

05:05

billion dollars in ninety seven years at these rates is modest wealth not Google

05:10

founder or drug lord wealth but you know nobody's gonna be crying for you either

05:15

fifty-seven