Inflation Transfers Wealth From The Poor To The Rich

Oct 4, 2010 [THE STAR]
by Milan Doshi

One of the key reasons that you must learn how to invest wisely is because of inflation. Inflation silently erodes the value of money and paper assets (e.g. fixed deposits, stocks, bonds, mutual funds, etc.) over time. The inflation rate that your family encounters is not the same as the Government’s official inflation rate for the entire country which hovers around 3 to 4% p.a.

Your family’s inflation rate is much higher, around 6 to 8% p.a. It is primarily dependent upon the parent’s and children’s lifestyle. Usually, children’s inflation rate is higher than their parents due to difference in lifestyles. Hence, any long term investments that do not give you returns above your family’s inflation rate are considered to be poor investments.

In this article, let me share with you how money is transferred from the poor to the rich. For easy explanation, I have taken the liberty to simplify many variables. We shall take the example of two individuals (Peter and Richie), both of whom have conservative risk profiles when it comes to investments. Both of them work hard, control their spending, defers gratification and have diligently saved RM100,000 for their retirement.

Profile #1: Peter
a) Believes that “Cash is King”. Hence, he leaves his money in a fixed deposit.
b) Prefers to rent all his life as he doesn’t believe in owning properties and is also afraid of borrowing money. (Many people may be unable to borrow money for property investments as they may have been blacklisted in the past by the banks. Hence they have no choice but to rent.)

Profile #2: Richie
a) Aware that cash and paper assets are just symbols, whereas hard assets such as real estate are reality. b) Decides to take a little risk and invest in a small property. He uses his RM100,000 towards a 50% down payment on a property worth RM200,000 as he doesn’t believe in high borrowings due to his conservative nature. Also, he opts for a short loan tenure of 20 years.

The 3 key variables we will consider are:
Fixed Deposit Interest Rate = 3% pa
Interest Cost on Loan = 5% pa*
Inflation Rate = 5% pa*

Simple Interest is used instead of Compound Interest. All other costs are ignored.

* Note: I have intentionally made the borrowing cost to be equal to the inflation for easy understanding.

What both Peter and Richie are unaware is: a) The bank uses Peter’s fixed deposit of RM100,000 @ 3% p.a. to lend Richie @ 5% p.a. for his property loan. The bank makes a profit of 2% p.a. for its services.

b) Peter rents a place from Richie and the rental is sufficient to pay for Richie’s monthly bank installments.

At the beginning...
Both Peter and Richie started out with a net worth of RM100,000. The only difference is that Richie has an asset value of RM200,000 and good debt of RM100,000.
 

20 years later....

Peter gets a return of 3% p.a. on his fixed deposit. Using simple interest, his fixed deposit will grow to RM160,000 (i.e. RM100,000 x 3% pa x 20 years) in nominal terms. However. with inflation running at 5% p.a., he is in actual fact. losing 2% p.a. or RM2,000 every year. Multiply that by 20 years, Peter’s original RM100,000 fixed deposit is only worth RM60,000 after inflation!

On the other hand, Richie’s property appreciates by 5% p.a. or RM10,000 per year. Multiple that by 20 years and his property doubles in value to RM400,000, thanks to inflation. Also, his liability becomes zero as his original loan (the money from Peter’s fixed deposit) is fully settled, thanks to the monthly rental income from Peter.

Analysis of both profiles
• Peter
By not taking risks and leaving his money in a fixed deposit, Peter will lose out in the long run because of inflation. While cash may be king in the short term, over the long run, cash becomes a pauper. Peter is not only back to square one (only happens if fixed deposit returns = inflation rate,) but in fact "poorer" as his money is now worth a lot less as it has reduced buying power.

• Richie
Richie comes out ahead of Peter despite his conservative nature. All he did was to take a little risk by investing in a small property with a small loan of 50% for 20 years. Ironically, it is Peter who helped both Richie and the bank get richer. Peter has indirectly lent Richie the money to buy the property. Furthermore, Peter pays the monthly rental to Richie who then pays the bank for his loan.

Evaluate your investments
At the end of the day, Peter's loss is Richie's gain and the above is an example of wealth redistribution in action, or how money gets transferred from the poor to the wise investor. People who do not know how to use good debts to their advantage will eventually end up losing their savings.

Don’t invest in any long term investments that give you returns that are lower than your family’s inflation rate. Instead, learn to invest wisely in hard assets like properties where inflation works for you.