In addition to death and taxes, inflation is another phenomenon that we can expect with near certainty over a period of time.
The U.S. has actually gone through many brief periods of deflation, but in general, economic progress is accompanied by inflationary pressures. 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—rise at a rate equal to or greater than inflation, the negative effects of inflation are neutralized.
Yet, as we've seen time and again, that usually is not the case. While the minimum wage has increased, the overall price of goods has outpaced the average salary increases of recent years.
The Worst Tax
Inflation is often referred to as the "worst tax" because its effects go unnoticed by most people. Hypothetically, earning 4% in a savings account while inflation grows at 7% makes many feel 4% richer. In fact, they are 3% poorer.
That's why it's important for households and investors alike to understand the causes and effects of inflation, and how to plan so as to ensure that their assets maintain their purchasing power.
Here are three investment approaches everyone should consider as ways of protecting their hard-earned wealth from the ravages of inflation.
Although inflation may be less dramatic than a stock market crash, it can be more devastating to your portfolio.
Invest in Stocks
Despite the lack of confidence most people express about stocks, owning some equities can be a very good way to combat inflation. Think of your household as a business. If a company cannot properly invest its money in projects that will deliver a return above its costs, then it, too, will fall victim to inflation. The basic premise of business success is that corporations will sell their goods at increasing prices, which will lead to elevated revenues, earnings, and inevitably, stock prices.
Some of the best stocks to own during inflation would be in companies that can increase their prices naturally during inflationary periods. Commodity resource companies are one example. Products like oil, grains, and metals enjoy pricing power during periods of inflation. The prices of these items tend to go up as opposed to, for example, the price of a computer, which is subject to manufacturer and distributor price adjustments.
Still, price increases aren't enough to protect against inflation. If a company experiences rising expenses, price increases alone are not enough to maintain 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.
Look to invest in businesses such as commodity firms or healthcare companies that possess the strongest profit margins and, generally, the lowest cost of production. Finally, never underestimate the value of dividends during periods of inflation. Dividends increase the total return of a portfolio.
Invest in a Home
When done for the right reasons, like buying a home to live in, real estate is always a good investment. Problems occur when a buyer's goal is to flip the property they just bought at a profit. Although experienced real estate investors are able to find hidden values in properties, the average person should focus on purchasing a home with the intent of holding it, even if only for a few years. Real estate investments do not typically generate a return within several months or weeks; they require an extensive waiting period in order for values to increase.
As a home buyer, unless you're paying cash, you're likely to put some money down and take out a loan, known as a mortgage, for the remainder of the purchase price. There are different types of mortgages—fixed-rate and adjustable are the most common—but the underlying principle is the same. You pay off a little of the principal each month until you're left with ownership of a debt-free asset that should continue to appreciate over time.
If you get a fixed-rate mortgage, you end up paying off future debt with cheaper currency if rates increase. But if rates decrease, you're still responsible for the fixed amount. Various factors should be taken into account in order to determine your best mortgage option.
Like land, home prices tend to increase in value on an average year-over-year basis. It is true that real estate bubbles are usually followed by correctional periods, sometimes causing homes to lose over half of their value. Still, on average, housing prices tend to increase over time, counteracting the effects of inflation.
Invest in Yourself
By far the best investment you can make to be prepared for an uncertain financial future is an investment in yourself. One that will increase your future earning power.
This investment begins with quality education and continues with keeping skills up-to-date and learning new skills that will match those most needed in the not-too-distant future. Being able to stay on top of a business's changing needs may not only help to inflation-proof your salary, but also recession-proof your career.