How can investing help someone beat inflation?
This concept doesn't really make sense to me. Can someone clarify how investing can help an individual beat inflation?
I love this question. Inflation eats away at purchasing power, meaning if you have $1 now and do nothing with it, it just sits on the kitchen table (the kids do their homework around it). If we spent that $1 now, we could buy 10 widgets (a pretend product). If we leave it on the kitchen table and pick it up in ten years, it might only buy 7 widgets. Our money was safe, but the $1 is worth less. The price of the widgets increased while the dollar stayed the same. With inflation, the price of everything generally increases.
We have not had inflation in a long time and the fear is that many people that own things like bonds will lose purchasing power and be able to buy less widgets.
Investing can be a hedge against inflation in two ways. 1) The growth in the investment regardless of inflation and, 2) the investment might be a "real" asset and go up in price with everything else.
If we invested the $1 example:
- Bought a bond that returned 2% (it might not keep pace with inflation but we might be able to buy 8 widgets instead of 7)
- We invest in real estate that had a total return of 3.5% ("real" assets often keep place with inflation which will often increase their value along with other assets)(you can still buy 10 widgets)
- We invest in stocks that return 6% (the companies have "real" assets that might be worth more and some companies might have pricing power, able to increase prices as prices in general rise)(you can now buy 15 widgets)
Mark Struthers CFA, CFP®
First, it's important to specify what you're investing in. If you're trying to keep ahead of inflation (which is the silent killer to most retirement income plans), then investing in high-grade US government bonds isn't going to help at all. Historically, equities (and particularly, common stocks) have provided the best investment returns, net of inflation. There's natural inflation in any economy from monetary and fiscal policy impact, so incorporating assets that have a history of doing better than the inflation rate helps people maintain their purchasing power over time. Here's a helpful link to more detail on this subject: http://www.investopedia.com/articles/investing/052913/inflations-impact-stock-returns.asp
I'm glad you asked this question because it's a phrase that's often used, but often misunderstood. The point of investing to help beat inflation is to gain purchasing power. Here's how that works:
Since the end of World War II, the average inflation rate has been 3.8% annually and over the latest 10 years, inflation has been only 1.8% annually. Inflation erodes purchasing power, but if your assets increase in value above the inflation rate, your purchasing power will increase. And vice-versa.
So how does investing help? Since 1926, the average annual return on equities (stocks) has been about 10%. The average annual return on bonds has been about 5%. Investing in either or a combination of the two would have gotten you a return in excess of the inflation rate. And that's how investing helps beat inflation.
I hope this clarifies the issue. Good luck!
The general premise is that you want your investments to produce a net return that is ahead of the current prevailing inflation rate in order to maintain purchasing power. As an example, many of my ultra conservative clients will put an abundance of cash in a CD earning 1%, when the prevailing inflation rate is +/- 2%. It feels safe to them, but all they did at the end of the year was lose 1% of their purchasing power. Over time, it becomes a slow leak or drain if you will on their assets, all but assuring they will not have enough capital to address future needs.
In order to "beat" inflation as well as grow your capital to account for not only inflation, but future spending requirements, your allocation must provide the ability to meet all of those needs. How much you have to earn as an average is a relative number. It depends on how much you will need at a certain point to rely on for all or part of your expenses. Bottom line, a well diversified portfolio including equities, fixed income, and alternative investments designed to address return and volatility is still the best way to stay well ahead of the slow eating capital inflation bug in the long run.
One of the reasons to invest is to maintain purchasing power. Inflation eats away your purchasing power each year so you’re not able to purchase the same amount of goods down the road versus today. Investing tries to combat that by earning an amount of interest greater than inflation. Cash does not currently do that, investing in stocks has historically done that. For example, if you are sitting on $100,000 in a savings account, you are probably getting only 0.25% interest if you are lucky. If the current inflation rate is 2% annually, you risk losing 1.75% of your purchasing power per year. That number might not sound significant, but it can get significant over time. You want to make sure your money is earning at least as much as inflation so you can purchase the same goods with your dollars tomorrow as you do today. I hope this helps.