In Financial Literacy 1, 2 and 3 I discussed scarciTy, creativiTy and the first component of realiTy time, environmental factors all to which personal finance is subject. In the next several posts I’ll be discussing what I’ve named the “Natural Forces”; inflation, risk and probability, complexity and compound interest.
These forces operate like “laws of nature” in the world of personal finance, if you ignore them you do so at your own peril.
Inflation causes loss of purchasing power. That means a dollar in the future will not buy what a dollar does today.
For example: today I can buy a gallon of milk for $3, but 10 years from now it’s $5.
I’m making purchasing power the context, not inflation, because we think and plan in terms of dollars and what they’ll buy. We have a pretty good idea of what they’ll buy today but when it comes to what they’ll buy in the future it get’s fuzzy. For one, it’s difficult to imagine the dollar in your pocket only being worth 50 cents and two, this erosion in value generally takes place slowly so that it’s virtually imperceptible when measured from month to month or from one year to the next.
Inflation’s causes are many, complicated and not necessary to get into for the scope of this post. So let’s go to more purchasing power examples which dramatize the take away points. If inflation averaged 3% per annum over the next 30 years $1 today would have $.74 of purchasing power, worth, in 10 years, $.55 in 20 years and $.41 in 30 years. If inflation averaged 4% it’s worth would be $.67 in 10 year, $.46 in 20 years and $.31 in 30 years. Given that plans typically run from 10 to 50 years the inflation factor is always one you need to work in.
Risk and Probability
Risk is the possibility of a negative outcome; harm, danger or loss. Losses are oft-times quantified in dollars. For example: my investments lost $15,000. Probability is the condition of an event being probable. That being the case, the likelihood or odds of that potential outcome occurring may be expressed in numeric terms. If one of the potential outcomes of an event is a loss, then generally that risk may be expressed as a probability. Example: in the next year the probability of my investments losing or making $15,000 is 25%. Another example: the probability that they will grow by $15,000 over 7 years is 80% while the probability they will lose $15,000 is 20%.
Although risk and probability impact virtually everything we do in the microcosm of personal finance it’s generally used to describe and evaluate investments and insurance needs. Investment examples: which stock has the greatest risk reward potential: GM, AIG or Goldman Sachs? What’s the probability my investment portfolio will grow to $1,000,000 in the next 15 years? What’s the risk associated with TIPS?
Insurance examples: what’s the chance I’ll become disabled and unable to work? Is there insurance for that? What’s the chance I could die young and leave my wife with big bills and no money to pay for the kids college? What if I don’t have health insurance? What if I have a major auto accident and I don’t have proper coverage?
As I’m sure you gather from the above risk and probability play a major role. In financial planning its essential to manage risk and work with realistic probabilities.
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