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. Should I include inflation-protected securities in my 401(k)?

    Learn how to protect your 401(k) from the adverse effects of inflation by adding inflation-protected securities to your portfolio. Read Answer >>
  2. Why are P/E ratios generally higher during times of low inflation?

    Inflation affects equity prices in several ways. Most importantly, investors are willing to pay less for a certain level ... Read Answer >>
  3. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
  4. When is the best time to invest in inflation-protected securities?

    Learn how to determine when to consider buying an inflation-protected security to enhance the returns of your investment ... Read Answer >>
  5. How can inflation be good for the economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
  6. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1994, and how the cost of living has changed above and beyond what can ... Read Answer >>
Related Articles
  1. Insights

    Inflation's Impact On Stock Returns

    When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ...
  2. Investing

    Retirement Planning: Why Real Rates of Return Matter Most

    Here's how to plot your real rate of return, understand your "personal inflation rate" and safeguard your retirement funds against inflation.
  3. Investing

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  4. Insights

    Inflation And Economic Recovery

    Inflation impacts the costs of every facet of the economy. Discover how it can help or hinder the economic recovery.
  5. Retirement

    Inflation And Your Retirement

    When you're setting financial goals and saving for retirement, don't forget to factor in inflation. Here's how to fight back and protect your future.
  6. Insights

    How Inflation Affects Your Net Worth

    When calculating your net worth, don't forget to take inflation into account.
  7. Financial Advisor

    Corporate Bonds and the Impact of Inflation Risk

    The impact of inflation risk affecting corporate bond returns can be significant. It may even result in a real loss of purchasing power.
  8. Insights

    The Importance Of Inflation And GDP

    Learn the underlying theories behind these concepts and what they can mean for your portfolio.
  9. Insights

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
RELATED TERMS
  1. Inflation Trade

    A method of investing that seeks to profit from an overall increase ...
  2. Inflation Protected

    The types of investments that provide protection against inflation ...
  3. Inflation-Protected Security - IPS

    A type of fixed-income investment that guarantees a real rate ...
  4. Inflation

    The rate at which the general level of prices for goods and services ...
  5. Inflation-Protected Annuity - IPA

    An annuity investment that guarantees a real rate of return at ...
  6. Headline Inflation

    The raw inflation figure as reported through the Consumer Price ...
Hot Definitions
  1. Foreign Exchange Reserves

    Foreign exchange reserves are reserve assets held by a central bank in foreign currencies, used to back liabilities on their ...
  2. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that decreased and eventually eliminated tariffs to encourage economic activity ...
  3. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  4. Derivative

    A security with a price that is dependent upon or derived from one or more underlying assets.
  5. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  6. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
Trading Center