Inflation and compound interest

Financial literacy

Inflation, compound interest & the time value of money

Financial illiteracy is pervasive. But the basics of compounding and inflation are arguably some of the most important things you should know (when it comes to money). Give us a few minutes of your time and allow us to take you through some basic explanations and examples on inflation and compound interest. You’ll thank us later.

  1. Let’s go back to the beginning
  2. Financial illiteracy
  3. Inflation
  4. Compound interest
  5. Time value of money
  6. It’s a very good place to start

Let's go back to the beginning

This blog post is part of a podcast series we’re doing to help you recognise the biases that influence your financial decision-making. But before we dive into the behavioural biases, we’re going to first take a look at some of the most common pitfalls that get us into financial trouble.

A very important disclaimer before we begin: please don’t ever feel like what we’re saying is meant to point a finger at you. Pretty much everyone experiences financial trouble at some point in their life. It’s simple human nature.

There are many reasons why we’re not always that great when it comes to managing our money. For this episode, we’re going to focus on just one pitfall. One that talks about the importance of understanding the power of inflation and compound interest. Next to behavioural biases, I think this one is the biggest of the lot.

Catch our podcast episode on our Youtube channel or on your favourite podcast platform. Or, just continue reading….

Financial illiteracy

Financial trouble - Preparing for retirement

According to one custom in-depth study here in South Africa, our average overall financial literacy test score stands at 54. That’s not very high when you think that this knowledge – or lack of knowledge – impacts our ability to make and save money.

One example quoted in this study is that only 23% of adults in South Africa understand what inflation is and how it works. This is one of the basics of finance. The numbers are also quite concerning when you consider the fact that most adults don’t seek out the advice of a financial planner. If you don’t have the appropriate level of financial literacy and you don’t have someone advising you, how will you make the best financial decisions?

According to one custom in-depth study here in South Africa, our average overall financial literacy test score stands at 54. That’s not very high when you think that this knowledge – or lack of knowledge – impacts our ability to make and save money.

One example quoted in this study is that only 23% of adults in South Africa understand what inflation is and how it works. This is one of the basics of finance. The numbers are also quite concerning when you consider the fact that most adults don’t seek out the advice of a financial planner. If you don’t have the appropriate level of financial literacy and you don’t have someone advising you, how will you make the best financial decisions?

Financial trouble - Preparing for retirement

We had a chat with Wynand Gouws, a certified financial planner and wealth manager at the award-winning Gradidge Mahura Investments, and author of To 100 and Beyond.

He shared a very sobering (excuse the pun) example with us:

At the moment your regular expenses include a basket of stuff; bread, milk, and a bottle of wine. If you don’t plan for your money to grow with inflation it means in 10 to 12 years, you can only buy half the basket. So, what don’t you do? Do you leave out the wine? Do you leave out the bread? Or do you leave out the milk?

That’s a stern warning of how we need to get compound interest to work for us to combat the impact of annual inflation. And that introduces us to the three basic concepts for financial literacy which we’re discussing in this post: inflation, compound interest, and the time value of money.

So it’s a good thing you’re here. Reading this post. When you’re unable to get to grips with the most basic elements of financial literacy – inflation and compound interest – then you are always going to struggle to save. So, let’s tackle them one by one…

Inflation

It’s a fairly simple concept – inflation is an increase in the general price of goods or services over time. And this leads to a decrease in our purchasing power. Just look at how the cost of a Spur burger, a tin of Ricoffy and a can of condensed milk has changed since the 1980s. Can you just imagine what these prices are going to be another 40 years from now?

Compound interest with inflation formula

You see, inflation is all about supply and demand. Simple economic theory. If there’s an increase in demand for goods and services that cannot be met by supply, well then you’ve got what’s called “too much money chasing too few goods” and the price of those goods will go up. This is known as demand-pull inflation.

When there’s too much money chasing too few goods you get what’s called DEMAND-PULL INFLATION Click To Tweet

OR… you have what’s called cost-push inflation. This is where the price imposed by the producers of those goods go up. Perhaps there were wage increases with the manufacturer, so their costs go up. Those increased costs then get pushed onto everyone else further down the line. By raising the costs, prices are “pushed up”.

Either of these two scenarios will result in prices going up… And you need to anticipate that. R100 today is not going to buy you the same basket of goods next year.

Your cost of living basically doubles every 10 to 12 years at current inflation rates.

Wynand GouwsCFP

The South African Reserve Bank targets an inflation rate of between 3 and 6%, so that’s generally what we can expect to see… However, there are times when we go outside that band. In January of 2023, our inflation rate was close to 7%.

And if you’re wanting to understand how the Reserve Bank can “manage” our inflation, when you’ve just learnt it’s got to do with demand and supply (which is not that easy to manage), well… they do that by increasing and decreasing the interest rate. I’m going to park THAT relationship for now… I want us to stay on inflation.

Because… even though we can expect consumer inflation to be somewhere between 3 and 6%, you must always remember that this is a general inflation number, it’s not necessarily reflective of the basket of goods that YOU buy.

As an example, food inflation was at 14%. Onions specifically, went up in price by 49%! In one year! How are we meant to keep up with the cost of food – amongst other things – with that inflation rate?

I can’t see us all banking salary increases of that much. Can you?

So, what else can we do? Well, we need to ensure our investments grow at a rate that can beat inflation. And that’s just one of the reasons why you ALWAYS need to be mindful of inflation data. Next up – compound interest.

Compound interest formula with inflation

Compound interest

Most of us have heard that Albert Einstein famously referred to compound interest as the 8th Wonder of the World. He went on to say that those who understand it, earn it… and those who don’t, will pay it. Remember, Einstein was a physicist, working on a very large scale, with a very long timeframe.

To help you understand how immensely powerful compound interest is, let me tell you about the Rule of 72 , a simple compound interest calculator. The Rule of 72 helps us determine the number of years it will take for a sum of money to double. All you do is you take 72 and you divide it by the simple interest rate. Coming back to what we said about food inflation being 14% earlier. 72 divided by 14 = 5. In 5 years (if food inflation continues to hold at 14%) the price of food will be double it is today. Scary!

But the good news is we can use this rule with our investments as well. If your investments are giving you returns over 7% – your money will double in just over 10 years! Now come on… it’s easy to see why compound interest is the 8th Wonder of the World.

Compound interest on investment

Let me quickly tell you a story:

Aviwe and Lwazi are the same age and were best friends growing up. They both worked hard and received scholarships to study. Their hard work has paid off and they’ve just landed nice paying jobs. On his 23rd birthday, Aviwe decided that he will start to invest right away. He puts R2 000 every year for 8 years in an investment that averages a 12% interest rate. At the end of the 8 years, Aviwe has put a total of R16 000 into his investment and stops contributing to it. Lwazi decides he will start saving later. On his 33rd birthday, he starts putting R2 000 into an investment every year and does so until he turns 65. He got the same 12% interest rate as Aviwe, but he invested for 25 more years than Aviwe. Lwazi invested a total of R66 000 over 33 years.
Does inflation compound

So, on their 65th birthdays, Aviwe and Lwazi decide to compare their investments. Who do you think had more? Aviwe, with his total of R16 000 invested over 8 years, or Lwazi, who invested R66 000 over 33 years?

Well, Aviwe is sitting with just short of R1.5 million as his future value. Lwazi has just over R750 000. In short, Aviwe has DOUBLE the amount of money that Lwazi has.

It’s really quite a remarkable personal finance story. Both Aviwe and Lwazi earn the same return. Lwazi puts away so much more than Aviwe. But… because Aviwe put that money away early, what happened? His money worked for him. Compound interest happened. And compound interest started compounding.

On the less positive side, please note that we’ve focused on compound interest in relation to savings accounts and investments. Just remember that it also applies to money that you’ve borrowed. If you’re not paying your debt, and you’re being charged interest on what you owe… guess what… that interest is compounding.  Don’t forget that.

Last up, the time value of money.

The time value of money

What this term means is that basically the value of money isn’t fixed. Having R100 in your pocket five years ago meant that you could buy a lot more than you can today. It’s all linked to inflation, the first term we spoke about, and how our cost of living increases each year. So, there are no technical things to understand with this term. This is all about having the awareness that the value of money changes. Each year, a loaf of bread costs you more, so each year, your R100 gives you less.

This is a very important term to understand when it comes to planning for your retirement. In your 30s and 40s, you might be living comfortably on R20 000 a month. Fast forward to when you’re in your 60s and 70s, you’ll need more than that every month…. Because the value of the money you’ve saved will change. And you need to get your head around that…. I need R20 000 a month today… but when I retire, I’m going to need maybe R40 000 to pay for the exact same basket of goods. The longer you are from retirement, the greater the reduction in value is going to be. Consider what those numbers might be looking like on your income tax return?

The value of money changes. The amount of money in your hands isn’t always commensurate to it’s purchasing power. When you can’t see this or understand that, you’re suffering from a very sneaky bias known as money illusion!

How does inflation affect compound interest

It's a very good place to start

OK, so those are the key terms for financial literacy: inflation, compound interest, and the time value of money. There’s plenty more that you can start to research, but these are the ones we highly recommend you have a solid understanding of.

We’re going to be moving on to discuss some of the other financial pitfalls in the next episode, but we’d love to know if you liked what you learnt in this post. Would you like some more financial literacy information – understand some other terms and see more examples? If so, please let us know. Who knows? We might find a way to sneak some of it in later, or hey – we might even make a separate series on it.

See you next time.

Want to pin this post for later?

More in season 1 of the Nudging Financial Behaviour Podcast

In case you missed it, see our previous episodes in this season:
  • Welcome to the podcast – An introduction to our host, Dr Gizelle Willows, and the content you can expect from Season 1.
Or if you want to jump ahead...
  • How to manage your debtLifestyle creep and easily available debt can easily lead to overconsumption and insufficient savings. Let us help you learn how to manage your debt.
  • System 1 & System 2 -This post unpacks the workings of our brain, commonly referred to as System 1 and System 2 thinking. We chat to Dr Daniel Crosby to get some further insight.
  • The overconfident investor – We need to discuss the overconfident investor. He makes some poor investing decisions. But fear not, we’re here to help!
  • The social media echo chamber – The rise of social media and fake news is impacted by confirmation bias. It’s known as the social media echo chamber effect.
  • Narrow framing – Narrow framing, the compromise effect, glossing, and the enabling frame. We need frames to make sense of the world. But they cause problems.

  • The anchored traderAnchors tie us down and can have serious consequences for investors and traders. Don’t be the anchored trader.

  • Behavioural biases unpacked – We wrap up Season 1 of the podcast and hear about all of the behavioural biases that each of our interview guests have fallen prey to.

Do you understand the impact of inflation in the real estate market?

Can you see how interest rates affect your life insurance premiums?

Let us know in the comments below.

Interested in more financial literacy?

Would you like a separate series on it?

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About the Author

I am passionate about helping people understand their behaviour with money and gently nudging them to spend less and save more. I have several academic journal publications on investor behaviour, financial literacy and personal finance, and perfectly understand the biases that influence how we manage our money. This blog is where I break down those ideas and share my thinking. I’ll try to cover relevant topics that my readers bring to my attention. Please read, share, and comment. That’s how we spread knowledge and help both ourselves and others to become in control of our financial situations.

Dr Gizelle Willows


Dr Gizelle Willows

 

PhD and NRF-rating in Behavioural Finance