A:

Inflation is an economy-wide, sustained trend of increasing prices from one year to the next. An economic concept, 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 or purchasing power over time. Inflation also tells investors exactly how much of a return (in percentage terms) 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 rate 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.

Inflation occurs when the supply of money increases relative to the level of productive output in the economy. Prices tend to rise because more dollars are chasing relatively fewer goods. Another way of stating this phenomenon is that the purchasing power of each money unit declines.

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%).

Inflation and Asset Classes

Inflation has the same effect on liquid assets as any other type of asset, except that liquid assets tend to appreciate in value less over time. This means that, on net, liquid assets are more vulnerable to the negative impact of inflation. In terms of the broader economy, higher rates of inflation tend to cause individuals and businesses to hold fewer liquid assets.

Illiquid assets are also affected by inflation, but they have a natural defense if they appreciate in value or generate interest. One of the chief reasons most workers place money into stocks, bonds and mutual funds is to keep their savings safe from the effects of inflation. When inflation is high enough, individuals often convert their liquid assets into interest-paying assets, or they spend the liquid assets on consumer goods.

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. What causes inflation, and does anyone gain from it?

    In this article, we will examine the fundamental factors behind inflation, different types of inflation and who benefits ... Read Answer >>
  2. Why Are P/E Ratios Higher When Inflation Is Low?

    P/E ratios are generally higher during times of low inflation, but why is this the case? Read Answer >>
  3. 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 >>
  4. How does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1998, and how the cost of living has changed above and beyond what can ... Read Answer >>
Related Articles
  1. Investing

    Maximize Your Real Rate of Return for Retirement

    Learn to understand how to plot your portfolio's real rate of return for retirement planning to safeguard your retirement funds against inflation.
  2. Investing

    Fidelity Investments: Commodities, Gold, Real Estate Are Plays on Rising Inflation

    Looking for ways to protect your investments in a rising inflation environment? Fidelity points to commodities, gold and real estate.
  3. Retirement

    Retiring: Is $1 Million Enough?

    Find out why this magic number has lost some of its lustre as a retirement savings target.
  4. Financial Advisor

    The Top 5 Ways to Hedge Against Inflation

    Here are five ways to hedge against inflation if it reappears on the horizon.
  5. Investing

    How S&P 500, Dow Stocks May Get Killed by Low Inflation

    Investors beware. Today's low inflation may no longer help stocks outperform
  6. Investing

    3 Stocks to Protect Your Portfolio From Inflation (CLX, GILD)

    Discover three stocks to protect portfolios against inflation. The best companies to protect against inflation are those with pricing power.
  7. Insights

    All About Inflation

    What causes inflation? How does it affect your investments and standard of living? This tutorial has the answers.
RELATED TERMS
  1. Inflation Protected

    Inflation protected refers to types of investments that provide ...
  2. Inflation-Protected Security - IPS

    An inflation-protected fixed income security, typically issued ...
  3. Headline Inflation

    Headline inflation is the raw inflation figure reported through ...
  4. Core Inflation

    Core inflation is the change in prices of goods and services ...
  5. Inflation-Protected Annuity - IPA

    An inflation-protected annuity - IPA - is an annuity that guarantees ...
  6. Base Effect

    The base effect is the distortion in a monthly inflation figure ...
Trading Center