Another post in my Teaching my kids series – Part 18: Inflation
As frequent reader of my blog you know that I’m writing some posts to try to financially educate my kids. I know they are still very young (6 and 9) but it is never too early to start. And they can read these blog posts later on in life 😉 (This is probably the case, because they don’t speak or read English very well at this moment – You got to love an understatement!).
This is another blog post to keep the “snowball of knowledge” rolling.
I think when you educate kids about money, they will benefit from it for the rest of their lives. Or as the saying goes: “What is learned in the cradle is carried to the tomb”. And to educate your kid is your responsibility as a parent.
This blog post is a post for my kids when they are a little bit older. I did not talk to my kids about this subject (yet).
Last week my oldest kid heart something on the radio about inflation and that it is rising. She asked my what inflation was and if it was a good thing.
What is inflation?
What is inflation actually, how does it start and what effect does it have on my money? All lot a question, but first lets look at what Wikipedia says about it:
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.
And now in words that my children can understand: When you have inflation you can buy less goods (e.g. candy) with the same money compared to last year for instance. You have a reduction in your purchasing power.
How does inflation start?
The easiest way to put it is that inflation has occurred when the average price of those goods and services has increased. Okay but how does the average prices rises.
If the central banks lower the interest rates, it is cheaper to borrow money and your savings will generate less interest. So in general these two factors lead to people and companies spending more money. And when people and companies start spending more money, the economics will blossom. So you can say that low interest rate drives economic growth.
Okay and what happens when the economy is growing? In a growing economy there is an increasing demand for goods and services over time. Companies cannot keep up with that at a given moment and they will hire additional people, which will cause wages to rise. Ultimately, companies must therefore ask more for their products and ta-ta: there is your inflation.
What effect does inflation have?
Normally you will see a rise in inflation within one and a half to three years after the central banks lowered their interest rates (that is what I learned in school). Why do I say normally, because the European Central Bank (ECB) is pumping huge amounts of money into the economy (they call it Quantitative Easing – QE) and therefore it takes longer before inflation really picks up.
But inflation will occur, also here in Europe. And with inflation, the prices of goods and services that we spend our money on every month, will increase. Therefore it makes life more expensive. So inflation is not good for our daily life.
But what about inflation and the stock market?
Inflation has a positive effect on the stock prices because inflation has a positive effect on the profitability of companies. Their turnover and the input costs increases and that is why the profit also increases. And because most of the costs are fixed (rent, depreciation, interest) the profitability is higher than the inflation rate.
In general, a slight rise in inflation is positive for stock prices, but high inflation is not.
And what about inflation and bonds?
This is a question that can be answered very quickly. With inflation, the value of a bond is going down. Inflation is the worst enemy for bonds. So if inflation will continue to rise, as predicted, the value of your bond investments will go down.
If you still want to keep investing in bonds then start investing in active bond funds that protect themselves against the risk of inflation. In my opinion bonds are an essential part of a good and well balance portfolio and therefore are always, regardless of inflation, a good buy.
This is my eighteen blog post about teaching my kids. I hope my kids at the age of say 18, have all the financial knowledge I’m having right now. This would be a huge advantage for them! And that’s why I started these blog post series.
What do you tell your kids about money and investing? Do you own bonds? And what are your thoughts about inflation?
I like to hear from you!
Help me get the “snowball of knowledge” rolling and share this post.
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