You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 – a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 – 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R – i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R – i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

1. Ridgewells Diner (Bethesda, MD) serving 40 people: Now costs $9795 – up 31% from last year.
2. Lenox, Williamsburg Shell pattern silverware, 4-piece place setting for 12: Now costs $6960 – up 28% from last year.
3. Natural Russian sable coat, Maximilian at Bloomingdale’s: Now costs $225,000 – up 18% from last year.
4. Nautor’s Swan 70 sailing yacht: Now costs $4,771,550 – up 17% from last year.
5. American Academy of Facial Plastic and Reconstructive Surgery: Now costs $17,000 – up 17% from last year.
6. Men’s black calf wingtip shoes, custom-mad, John Lobb, London: Now costs $4566 – up 11% from last year.

Not that I am worried about such a list (hey, if I want a boat ride, I’ll get myself a $20 ticket to one of those “sea screamers” down in Florida, rather than pay $4,771,550 for a yacht).

Do you think the ultra-rich will zip up their money-belt now? Hardly so – their earning grows at way more than 6%, whereas our salary barely keeps up with inflation.

The short answer to this question is that we should invest to be able to shift our purchasing power from the high earning phase of our life to the low earning phase. Many of us earn more than we need to spend in our working life (note the italic – some of us spend more on our wants rather than our needs). It is the exact opposite when we retire – we spend more on our needs than we earn. Therefore, we must have adequate funds available when we retire to live out the rest of our life.

It used to be easy before. Most employers offered pension schemes that guaranteed a steady paycheck for their ex-workers as long as they lived. This concept has almost become a thing of the past. Instead employers today offer various “retirement plans” that encourage workers to sock away a portion of their payment for the future. In short, the burden of supporting yourself in retirement has shifted from your boss to you.

The primary objective of investing is then to have a reasonably comfortable life after retirement. (Increased longevity extends our retired life, not the working life. With the average life expectancy of 78 years in America today, we are talking of almost 20 years in the sunset, and even longer for some.) One way to achieve this goal is to store the “excess fund” during our working period as financial assets, such as stocks and bonds. After retirement, we sell these assets to meet our consumption needs.

We are talking of shifting the purchasing power of money, not the money itself. With inflation steadily eroding the value of a financial asset with time, a dollar 30 years later will buy a lot less than it can buy today (I bet you won’t begin your breakfast with a 99¢ cheese burger then.) So, our asset must at least grow apace with inflation just to preserve its purchasing power. (From the recent CPI data, this means the return of our investment should be at least 2.5%.)

Merely compensating for inflation is not enough, though. Remember that our paycheck reduces drastically after retirement (it vanishes altogether for most). We must have enough assets accumulated by that time to be able to steadily draw out from them for many more years, without facing the risk of outlasting them. So, the derivative goal of investing is to implement a strategy of growing our asset as fast as the prevailing market conditions allow.

I have used the words “asset” and “financial asset” a few times here. In the next post, we will see what they really mean.

The money market yield of a brick-and-mortar bank averages a measly 0.5% nationally, which means the money parked in there loses its value at 2% a year (taking the CPI of 2.5% as the measure of inflation). By contrast, yields offered by the web-only banks often exceed 5%, outpacing inflation by a fair clip. Unburdened of the cost of maintaining an elaborate branching network, they can afford to give generous yield to their clients.

These banks are also trying to lure away customers from competitors by offering slightly better yields. Of course, it does not make much sense to jump from one bank to another every other day for a mere 0.1% difference. Unless you have lot (really lot!) of money riding on this, the gain of a few bucks cancels out in the process of transfer itself, which usually takes a few days to complete, and you do not get interest for those days.

Besides money market accounts, these banks offer vastly superior yields on their short-term CDs and interest checking accounts. The check writing privileges, often without any additional fees, is what really makes online banking that much more convenient. For those concerned with security issues, money invested in most Internet-only banks is FDIC insured for upto $100,000, same as any brick-and-mortar bank can offer.