What is inflation and how should it affect my investing?

By Investopedia Staff AAA
A:

Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return (%) their investments need to make for them to maintain their standard of living.

The easiest way to illustrate inflation is through an example. Suppose you can buy a burger for $2 this year and yearly inflation is 10%. Theoretically, 10% inflation means that next year the same burger will cost 10% more, or $2.20. So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy as many burgers. However, a one-time jump in the price level caused by a jump in the price of oil or the introduction of a new sales tax is not true inflation, unless it causes wages and other costs to increase into a wage-price spiral. Likewise, a rise in the price of only one product is not in itself inflation, but may just be a relative price change reflecting a decrease in supply for that product. Inflation is ultimately about money growth, and it is a reflection of too much money chasing too few products.

With this idea in mind, investors should try to buy investment products with returns that are equal to or greater than inflation. For example, if ABC stock returned 4% and inflation was 5%, then the real return on investment would be minus 1% (5%-4%).

So, you can protect your purchasing power and investment returns (over the long run) by investing in a number of inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These types of investments move with inflation and therefore are immune to inflation risk.

For further reading, please see Inflation-Protected Securities - The Missing Link and our Inflation Tutorial.

RELATED FAQS

  1. What is the difference between consumer surplus and economic surplus?

    Learn the difference between consumer surplus and economic surplus, how the concepts are related and the important theoretical ...
  2. What does it signify about a given product if the consumer surplus figure for that ...

    Find out about high consumer surplus and what it means for utility and the structure of supply and demand in the market for ...
  3. Is credit a form of fiat money?

    Discover what fiat money is, learn how it developed historically into its use in most modern economies, and explore its relationship ...
  4. What is the difference between fiat money and representative money?

    Learn the main differences between fiat money and representative money. Differences include actual physical currency and ...
RELATED TERMS
  1. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
  2. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is an unconventional monetary ...
  3. Nordic Model

    The social welfare and economic systems adopted by Nordic countries.
  4. Insurance Inflation Protection

    Insurance inflation protection is designed to allow policyholders ...
  5. Welfare Capitalism

    Definition of welfare capitalism.
  6. LIBOR

    LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate ...

You May Also Like

Related Articles
  1. Economics

    Gambling on Macau: Too Risky?

  2. Mutual Funds & ETFs

    GLD vs. IAU: Which Gold ETF is Better?

  3. Options & Futures

    Why Gold's Price is More than 'Supply ...

  4. Mutual Funds & ETFs

    These 4 Precious Metals ETFs Help Combat ...

  5. Investing

    What Has Been Groupon’s Growth Strategy?

Trading Center