Investing for Beginners

Inflation
The "inflation rate" refers to the percentage increase in the costs of goods and services over a year. Most people refer to changes in the Consumer Price Index (CPI) when they talk about the inflation rate.
Don't you miss the days when candy bars cost only a dime? Thanks to inflation, your child would be lucky to buy a gumball today with the same dime that you used for a Snickers® bar when you were a kid.

Inflation is what happens when the same goods and services cost more over time. When we say the cost of living has gone up, what we're really talking about is inflation. High inflation means that prices are going up quickly. Inflation has been around 3% per year lately, but it has been as high as 6% in the 1990s and was even higher in the 1980s.

Why does inflation matter? When you invest or save, you want to earn as much as you can on your money, over and above inflation (as long as you understand and are comfortable with the risks). The amount you earn after subtracting inflation is your "real return." Understanding inflation and your real return will help you understand what your money will buy when you're ready to spend it.

Example. Let's say you have your eye on a $20,000 car but want to wait until next year to buy it. Here's how inflation might eat into your plans if you don't invest your money carefully:

What you'll save if you put your $20,000 in a savings account that pays 2% interest a year:
$20,000 x 1.02 = $20,400

What your car will cost in a year, if inflation is at 3%:
$20,000 x 1.03 = $20,600

How much more money you'll need at the end of the year:
$20,600 - $20,400 = $200


What's the better investment?
  1. A savings account that pays 10% interest a year when inflation is 8%
  2. A savings account that pays 5% interest a year when inflation is 2%
The better answer is 2. Even though the first investment pays more interest, inflation eats away most of it. After inflation, you'd make 2% (10% - 8% = 2%). You'd make more after inflation on the second investment, because your real return would be 3% (5% - 2% = 3%).

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  • Friday, April 18, 2014 is a stock market holiday. Therefore, transactions requested after 4 p.m. ET on Thursday, April 17 in your FRS Investment Plan account will be processed using the closing prices of the next business day, which is Monday, April 21.