Taking Small Risks to Beat Inflation

Milan Doshi explains in simple terms how the poor are making the rich richer. Even small risk-taking pays off big-time

Inflation – A Silent Disease

One key reason why you must Learn How to Invest Wisely on Your Own is because of Inflation. Inflation is the silent disease that will erode the value of money and paper assets (eg fixed deposits, stocks, bonds, mutual funds, etc) over time.  The inflation rate your family encounters is not the same as the government’s official inflation rate for the entire country which hovers around 3-4% pa.

Your family’s inflation is much higher, around 6-8% pa. It is primarily dependent upon you (the parents) and your children’s lifestyle. Usually the children’s inflation rate is higher than their parents due to differences in their lifestyles. Hence, any long-term investments not giving 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 simply because the Rich makes wiser investment choices than the Poor. Also the Rich knows how to make inflation work for them, whereas the Poor’s hard-earned savings often get eaten up by inflation.

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, defer gratification and have diligently saved RM100,000 for their retirement. They differ as follows:

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.

 * Note: 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.

Richie:
a) is 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 to have a short loan tenor 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.

Poor Unwittingly Pays Rich

What both Peter and Richie are unaware is:

a) The Bank uses Peter’s fixed deposit of RM100,000 @ 3% pa to lend to Richie @ 5% pa for his property loan. The bank makes a profit of 2% pa for its services.

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

In the Beginning

Both Peter and Richie start out with 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% pa on his fixed deposit. Using simple interest, his fixed deposit will grow to RM160,000 (ie RM100,000 x 3% pa x 20 years) in nominal terms. However with inflation running at 5% pa, he is in actual fact losing 2% pa or RM2,000 every year. Multiply 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% pa or RM10,000 per year. Multiply 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.

Notice from this highly simplified example: 

Peter: By not taking risks and leaving his money in a fixed deposit will lose out BIG Time over 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: Comes out far ahead of Peter despite his conservative nature. All he does is take a little risk by investing in a small property with a small loan of 50% for 20 years.   

What is ironical is that Peter is helping both Richie and the Bank get Richer at his expense. In fact, Peter has indirectly lent Richie the money to buy the property that he stays in. Further, Peter pays the monthly rental to Richie who then pays the bank for his loan. 

Leverage on Good Debts

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 whose returns are lower than your family’s inflation rate. Instead, learn to invest wisely in hard assets like properties where inflation works for you, otherwise inflation will eat you up instead!

If you have any comments on this article or questions, please email to me at http://achievers88@yahoo.com. I would highly recommend that you sign up at our moderated getrichbook egroups at:
 
http://finance.groups.yahoo.com/group/getrichbook/

It's free for all my book readers and readers of this article. Only relevant emails pertaining to finance, property and stock investments will be approved for broadcast.

Article Contributed by
Milan Doshi
Financial Trainer and Best Selling Author of
“How You Can Become a Multi-Millionaire Real Estate Investor!”
For more information, visit www.milandoshi.com