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 time again, that usually is not the case. The prime indicator of this effect is that, while minimum wages have increased, the overall price of goods has outpaced the average salary increases of recent years.
Thus, it's important for households and investors alike to understand how to invest and plan in such a way so as to ensure that your assets maintain purchasing power. Here are three approached all individuals should seriously consider as ways of protecting their hard-earned wealth from the ravages of inflation. (Inflation is less dramatic than a stock market crash, but it can be more devastating to your portfolio. To learn more, refer to Coping With Inflation Risk.)
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. You may be thinking – a business is similar to a household, and if a company cannot properly invest its money in projects that will deliver a return above its cost, then it, too, will fall victim to inflation. The basic premise is that corporations will sell their goods at increasing prices, which will lead to elevated revenues, earnings, and, inevitably, stock prices.
Therefore, some of the best companies to own during inflation would also be those 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 will likely go up in periods of inflation versus the price of, say, a computer, which is subject to manufacturer and distributor adjustments.
Still, simple price increases aren't enough. Remember that inflation typically leads to price increases across a spectrum of business operations. Thus, if a company experiences rising expenses in tandem with inflation, price increases alone are not enough to justify 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.
It makes sense to seek out the lowest-cost producer. Look for businesses such as commodity firms or healthcare names that possess the strongest profit margins. Finally, never underestimate the value of dividends during periods of inflation. Dividends increase the total return of a portfolio. In the lost decade of 2000-2009, when the S&P 500 went nowhere, dividends made a significant difference to those who received them. (Find out which futures, options, or funds will be your perfect commodity portfolio fit. See How To Invest In Commodities.)
Invest in a Home
Yes, even today, when done for the right reasons, real estate is a great investment. Problems with real estate occur when one's goal is to trade a home versus buying a home to live in. Although many experienced real estate investors are able to find hidden values in properties, most individuals should focus on purchasing a home with the intent of holding it, even if for only a couple years. Real estate investments do not typically work out within several months or weeks; they require an extensive waiting period in order for values to increase.
Mortgages for homes come in all varieties, although the general premise is essentially the same. Each month you pay off a little of the principle, and within 15-30 years you will have paid off the entire amount, leaving you with ownership of a debt-free asset that should continue to appreciate over time.
When you borrow at a fixed rate, any future increases in interest rates mean that you are paying off future debt with cheaper currency. Consider it as you would a bond: if you buy a house today at a fixed interest rate of 5%, and five years later the rates are at 8%, your cost of debt is a lot cheaper than it is for the present-day borrower.
Like land, home prices tend to increase in value on an average year-over-year basis. 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, counteracting the effects of inflation. Rather than holding money in a savings account, which will cause a major loss in purchasing power by the time you retire, real estate investments have the opposite effect. (Owning property isn't always easy, but there are plenty of perks. Find out how to buy in Simple Ways To Invest In Real Estate.)
Invest in Yourself
By far the best investment you can use to deal with an uncertain future that may include higher prices is to invest in yourself. Nothing is more effective in combating inflation than investing in yourself in order to increase your future earning power.
This investment begins with a quality education and continues by constantly striving to learn new skills that will match those most needed in the future. It's not mere coincidence that the higher one's level of education, the higher the pay and the greater the chance for employment. Further education allows one to not only inflation-proof one's salary, but also to recession-proof one's career.
More than stocks, bonds, or houses, investing in oneself is the easiest and most effective way to combat inflation and any form of economic turmoil. (Here are some pros and cons to consider before you take the charter plunge. For more information, read So, You Want To Earn Your CFA?)
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, while in fact they are 3% poorer. Learn to understand the causes and effects of inflation, and how you can protect your assets from its hidden tentacles.