In addition to death and taxes, inflation is another phenomenon that we can expect with near certainty over a period of time.
Indeed, the U.S. has gone through many brief periods of deflation, but in general, economic progress is accompanied with inflationary pressures. Basically, inflation may occur when there is too much money in the system, which leads to an escalation in the price of goods. Of course, if a household's two primary sources of wealth creation - asset and income appreciation - go up in value at a rate equal to or greater than inflation, the negative effects of inflation are removed. Yet as we've seen time and time again, that usually is not the case. The prime indicator of this effect is that while minimum wages have increased, the overall price of goods has outpaced the average salary increases recent years.
So it's important for a household and investors to understand how to invest and plan in a way to ensure that your assets maintain purchasing power. Here are three ways that all individuals should seriously consider to protect their hard earned wealth from the savages of inflation. (Inflation is less dramatic than a crash, but it can be more devastating to your portfolio. To learn more, refer to Coping With Inflation Risk.)
- Invest in Stocks
Despite the lack of confidence that most people often have about stocks, owning some equities can be a very good way to combat inflation. But you may be thinking: a business is similar to a household; if a company can not properly invest its money in projects that will deliver a return above its cost, then it too will fall victim to inflation. The basic premise is that corporations will sell their goods at increasing prices, which will lead to elevated revenues, earnings, and inevitably, stock prices.
Therefore, some of the best companies to own during inflation would also be those companies that can increase their prices naturally during inflationary periods. Commodity resource companies are one such area. Products like oil, grains and metals enjoy pricing power during periods of inflation. The prices of these items will likely go up in periods of inflation versus the price of a computer for example which is subject to manufacturer and distributer policy adjustments.
But simple price increases aren't enough. Remember, inflation typically leads to price increases across a multitude of business operations. Thus if a company experiences increase in its expenses in tandem with inflation, price increases alone are not enough to justify equity appreciation. That's why grocery stores, which may benefit from an increase in food prices, may also suffer from an increase in their cost of goods sold.
Instead, one should attempt to seek out the lowest cost producer. Look for businesses like commodity companies or healthcare names that possess the strongest profit margins. Finally, never underestimate the value of dividends during periods of inflation. Dividends increase the total return to a portfolio and in the lost decade of 2000-2009, when the S&P 500 went nowhere, dividends made a significant difference. (Find out which futures, options, or funds will be your perfect commodity portfolio fit. See How To Invest In Commodities.)
- Invest in a Home
Yes, even today, real estate is a great investment when done for the right reasons. The problem in real estate occurs when one's goal to trade a home versus buying a home to live in. Although many experienced real estate investors are able to find hidden values in properties, most individuals should focus on purchasing a home with the intent of holding it, even if for only a couple years. Real estate investments usually do not come to fruition over several months or weeks, but normally involve an extensive waiting period in order for values to increase.
Mortgages for homes come in all varieties, although the general premise is essentially the same. Each month, you pay off a little of the principle and, within 15-30 years, you will have paid off the entire amount, leaving you with ownership of a debt-free asset that should continue to appreciate in value over time.
And when you borrow at a fixed rate, any future increases in interest rates means that you are paying off future debt with cheaper currency. Think of it like a bond: if you buy a house today at a fixed interest rate of 5% and five years later rates are 8%, your cost of debt is a lot cheaper than it is for the present day borrower.
Like land, home prices tend to increase in value on an average year-over-year basis. Real estate bubbles are usually followed by correctional periods, sometimes causing homes to lose over half of their value. But on average, housing prices tend to increase, counteracting the effects of inflation. Rather than holding money in a saving account, which will cause a major loss in purchasing power by retirement, real estate investments have the opposite effect. (Owning property isn't always easy, but there are plenty of perks. Find out how to buy in Simple Ways To Invest In Real Estate.)
- Invest in Yourself
By far, the absolute best investment you can use to deal with an uncertain future that may include higher prices is to invest in yourself. Nothing is more effective in combating inflation than investing in yourself in order to increase your future earnings power potential.
This investment begins with getting a quality education and then constantly striving to learn new skills that will match those most needed in the future. It's not mere coincidence that the higher one's level of education, the higher the pay and the greater chance for employment. Further education allows one to not only inflation-proof his/her salary, but also recession-proof his/her career.
More than stocks, bonds or houses, investing in oneself is the easiest and most effective way to combat inflation and any form of economic turmoil is to increase your future potential earnings power by investing in yourself today. (Here are some pros and cons to consider before you take the charter plunge. For more information, read So, You Want To Earn Your CFA?)
The Worst Tax
Inflation is often referred to as the worst tax because its effects go unnoticed to most people. Hypothetically, earning 4% in a savings account while inflation grows at 7% makes many feel 4% richer, when in fact they are 3% poorer. Learn to understand the causes and effects of inflation and how you can protect your assets from its hidden tentacles.