Inflation is back. And it’s a hot topic again in the media.
We haven’t experienced disruptive levels of economic inflation since the early 1980s. Anyone who lived through that period is probably reluctant to relive those memories. For those who were borrowing money at that time, particularly, life was hard.
But economic inflation, while important, is not the most dangerous form of price increases. There is another, far more destructive, type of inflation that can wreak havoc on people’s finances over time. It’s called lifestyle inflation.
I worry far more about lifestyle inflation than I do economic inflation. You should too.
Most people understand economic inflation. It is the general increase in prices for things we buy – houses, vehicles, milk, bread, medical care, clothes, detergent, and many other goods and services. When production costs increase or when demand exceeds supply, prices rise. That is economic inflation.
So what is lifestyle inflation?
Lifestyle inflation is a far more individualized form of price increases. It is the tendency for people to spend more as their income increases. As we get promoted or start new jobs at higher salaries, we often use some or all of that increase in compensation to buy additional goods and services. After some time, we simply get used to this higher level of spending and it becomes our new standard of living.
When lifestyle inflation creeps in – bigger house, newer vehicle, more vacations, additional stuff – it becomes incredibly painful to cut back on those luxuries if income later declines – whether that be from a job loss or retirement. That is the danger of lifestyle inflation. We back ourselves into a corner that we don’t want to leave.
To be clear, both forms of inflation can be harmful.
Economic inflation can be devasting to investment portfolios – bonds and stocks alike. If your wages don’t keep up with inflation, you eventually lose purchasing power and erode your wealth as the things you buy increase in price while your income remains stagnant.
So why do I worry so little about economic inflation, and why do I suggest you worry less about it too? Two reasons.
For starters, we can’t change economic inflation. It is entirely out of our control. No matter what we do individually, we have no ability to affect economic inflation.
And second, there are very few reliable investment solutions to take advantage of high economic inflation. Commodities tend to perform well in inflationary environments – things like oil, agricultural products, and precious metals. But it’s extremely difficult to successfully time the purchase and sale of commodities. I strongly suspect more money has been lost by investors who have tried and failed to properly time commodity trades than has ever been made by those who successfully bought and sold them.
While economic inflation is out of our control and is nearly impossible to profit from consistently, lifestyle inflation is totally under our control. We can choose to keep a lid on expenses.
Think of it this way. If you make $50,000 a year and have lifestyle spending needs of $49,000, you are far better off than if you made $100,000 but had lifestyle spending needs of $101,000.
Living on less than you earn is a superpower. It gives you options. If an opportunity arises, you have reserves available to profit from the situation. It also allows you to sidestep the pain of significantly cutting back on life’s luxuries if you are thrown a financial curveball at some point.
Keep in mind, economic inflation comes and goes, but lifestyle inflation has a nasty way of sticking around.
Manage what you can control. Diligently focus on lifestyle inflation. Leave the fussing about economic inflation to the talking heads in the media.