"Back in my day Freddos were 10p a pop. Now look at the price, two and a half times more than what used to pay. And every January, we brace a little for the increase price of living: potatoes, peas, and toilet paper. Whilst our wages stay the same."
Imagine, 20 years ago, a fiver would have got netted you 50 Freddos. That's enough Freddos to keep you busy for a while, whatever you're doing. Now, finding the same five pound note, going to the bank, exchanging it for a crisp, polymer note and heading to Sainsburys. That note isn't going far, only 20 Freddos. That's not fair.
Let's go back 20 years ago again. This time with the knowledge of increasing Freddo prices we have a goal to not get stung by the 250% price hike in 20 years. Playing it safe you look to the bank. Each year your bank gives you some money (interest) so that you can store your money with them. No risks involved, better than keeping it under the mattress right?
Not quite.
Perverse incentives
Everything in life has risk. Despite some banks lasting for over a century, crashes do happen and people lose money. In the short term, storing your money with a bank does pose a risk with fraudsters and compromised account details. But the same is true for house thieves peeking under your mattress. The payout, or interest given to you by the bank can be thought of as twofold:
- The bank pays you to incur risk of keeping your money safe.
- You receive interest as an incentive to lend them your money.
Your friend wants £100 for a fixed period. You negotiate that it isn't worth being £100 short this month so ask them for four Freddos in addition to the £100 on repayment. Your friend is trustworthy so you can be sure that they'll return the cash in full (and the four Freddos).
Now what you don't realize is that your friend is using the £100 to buy limited edition (Nike's) that are currently on sale. They predict that after the first release sells out, latecomers will be eager to buy from the second hand market. Especially since Christmas is nearing. Your friend is confident there will be at least one customer willing to pay £110 on Acme marketplace. However, there is a risk that he might not sell it at £110, maybe all of the offers he receives are just enough to cover the cost of your four Freddos and an extra for themselves. Maybe an offer of £120 comes along.
In nearly all scenarios, your friend benefits from the additional cash you provided them. Both parties win; each gaining profit in proportion the amount of risk taken.
Now what if you struck a deal with old-reliable. Instead of a fixed period and them asking for a loan, you set up an agreement entailing:
- Your friend keeps the £100 safe and in return pay you a Freddo a month.
- You agree that you can ask for the £100 at any point.
Now old-reliable has a conundrum, they will have to have the £100 spare at all times. By roping another person in, your friend has pockets £200 heavier. The risk of one person asking for the £100 back before you re-sell another pair of trainers goes down.
Why? That's a exercise for you, reader.
So, there's a problem. What if both parties want their £100? Add a third. And another. What if some people want to lend a tenner instead?
Again reader, that's for you to think about.
The cost of living
Every January we prepare ourselves for the increased prices of day to day goods like sliced bread, toothpaste and tea. This year the price of a standard white loaf may cost £1.05 instead of £1.00 - a 5% increase in price. This is inflation. To keep things simple:
- inflation is a measure of how prices of goods and services vary from year to year.
- in the last 5 years in the UK it has fluctuated between 0.2% and 5%. That is, for the last 5 years, the cost of goods and services have increased yearly by 0.2% to 5%.
- the UK Government has a target of keeping inflation low and stable at 2%1.
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If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending.
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But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.
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If we take the 2% as our starting point and we have £100, next year, the same amount of money will be worth £98. The same thing for wages. A £9 per hour shift will invariably be worth £8.82. And that is in the ideal case. In short, under inflation, cash lying around loses its value, a bit like a human body that never exercises- wastes away.
However, there are other ways of making your money resilient to inflation- we can't rely on our banks to match inflation; find me a bank that has a higher interest rate than inflation without any catches and I'll give you a unicorn pony (for a fee of course). We have to be more like our friend selling trainers; not exactly like our friend, the same principle applies.
Own and manage assets that are likely to increase over time.
"How does one do that with no knowledge of what assets are valuable and will increase over time? Property and stocks are the most obvious to me but I don't have enough money to buy a property and stocks are scary."
For now, research is your best tool at finding out what you should own. What are your goals? For your money to grow without doing anything but following simple rules? I'm afraid I can't help you there.
Investing, yes, whether that is buying vintage video games, collectable cards, cryptocurrency if you want to take on the risk follow the same rules: people hold onto assets as they believe, justified or not, that the value will increase and there are people willing to pay the increase price for the asset sometime in the future.