MONEY OBEDIENCE

How money loses its power of buying things

A few days ago we looked at market risk and how it is paired with other risks. Today we are looking a little closer at the risk that market risk will help you avoid, namely purchasing power risk.

What is purchasing power risk? Over time a dollar loses its value through inflation. For example, you could buy regular gas just over 10 years ago for say $1.30 per gallon. Now you pay more than twice as much. If 10 years ago you had put $1.30 into a savings account paying you an average interest rate of, say, 2% after-tax, then in those 10 years your $1.30 would have grown to an amount just shy of $1.60. You might have thought back then that playing it “safe” with savings would be the right thing to do, but that $1.60 can hardly afford a gallon of gas at today’s prices ($2.70/gallon). By playing it “safe” you assumed purchasing power risk. You may not have lost any real money – in fact you gained a very real 30 cents to reach $1.60 – but you certainly have lost a bit of your money’s power to buy gas, because that 30 cents cannot make up the difference in inflation. This is purchasing power risk.

Savings accounts have little risk of instability, but they have hidden purchasing power risk. To overcome that risk, you need to put your saving in a form that will give you a return that can at least match inflation, but better yet, earn you a few more pennies than that. So instead of putting the money in a savings bank, or storing gallons of gas in your basement (even if you have a basement, this plan is just not safe, and plus, there’s not enough space down there!) you have to make your money earn money in some other way.

If you invest some or all of your money in a risky asset such as the stock market, you will assume some market risk since your savings can actually go down in actual dollars, especially in the short term. But by investing in markets such as the stock and bond market you can lower or even eliminate the risk that your saved money will lose the power to purchase things over the long term, because the stock market and inflation tend to move in sync over time. On the other hand, if you do not invest any of your long-term savings in a riskier asset such as stocks or bonds, you leave yourself totally exposed to the risk that your savings will not buy as much as you thought it would when you are ready to spend your savings.

When you assume market risk (to avoid purchasing power risk, for example), you see very clearly how the risk affects your savings as the stock and bond market moves up and down. You feel the pain and pleasure of losing and making money almost anytime you look at your statements from your brokerage account. On the other hand, when you leave yourself exposed to purchasing power risk, you don’t notice for a long time that your money in the savings account or under the mattress loses its power of buying things. When you go out and you want to use your money kept “safely” in the bank, you will realize that your efforts to safe money do not really pay off as much as you had expected.

The hard fact is that to reduce purchasing power risk you have to assume some market risk. If you are able to keep you money there for the long run, you may want to invest some of your savings in risky things like stocks and bonds. (You need a lot of years to make money over the shorter-term volatility of stock prices.) Sure, with this strategy you take on additional (market) risk, but overall you lower overall financial risk because market risk and purchasing power risk balance each other out somewhat. (Unfortunately there is not much you can do about lowering purchasing power risk in the short term.)

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Posted in Investing