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. 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 >>
Related Articles
  1. 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.
  2. Insights

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
  3. 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.
  4. 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.
  5. Insights

    How Inflation Affects Your Net Worth

    When calculating your net worth, don't forget to take inflation into account.
  6. 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.
  7. Personal Finance

    Fight Back Against Inflation

    Inflation is often a consequence of economic recovery. Here's how you can protect your financial portfolio.
  8. Investing

    Timeless Ways To Protect Yourself From Inflation

    Inflation is a natural part of modern life - but there are some ways to cover your assets.
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 Annuity - IPA

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

    The rate at which the general level of prices for goods and services ...
  5. Inflation Targeting

    A central banking policy that revolves around meeting preset, ...
  6. Inflation-Adjusted Return

    A measure of return that accounts for the return period's inflation ...
Hot Definitions
  1. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
  2. Hard Fork

    A hard fork (or sometimes hardfork) is a radical change to the protocol that makes previously invalid blocks/transactions ...
  3. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  4. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  5. Zero Day Attack

    Zero Day Attack is an attack that exploits a potentially serious software security weakness that the vendor or developer ...
  6. Effective Tax Rate

    The average rate at which an individual or corporation is taxed. The effective tax rate for individuals is the average rate ...
Trading Center