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. Managing Wealth

    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. Markets

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  3. Retirement

    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.
  4. Markets

    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.
  5. Markets

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
  6. 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.
  7. Markets

    Macroeconomics: Inflation

    By Stephen Simpson Inflation is a key concept in macroeconomics, and a major concern for government policymakers, companies, workers and investors. Inflation refers to a broad increase in prices ...
  8. Retirement

    Combating Retirement's Silent Killer: Inflation

    Inflation can devour a once secure nest egg. Learn how to protect yours.
  9. Markets

    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.
  10. Markets

    The Importance Of Inflation And GDP

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

    The consequence of abnormally high or low levels of inflation ...
Hot Definitions
  1. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  2. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  3. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  4. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
  5. Weighted Average Life - WAL

    The average number of years for which each dollar of unpaid principal on a loan or mortgage remains outstanding. Once calculated, ...
  6. Real Rate Of Return

    The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other ...
Trading Center