You might be the kind of person who wants to invest to let your money do some of the work of earning and saving for you. However, if your money is not earning enough to beat inflation, you might lose money rather than make it. Inflation is the rise in the cost of goods and services over time and can eat away at your savings.
The Federal Reserve works to keep the rate of inflation around 2% per year. With that in mind, your assets should earn at least that much (more is better) to hold their value. Find out how to beat this value stealer with mutual funds.
- Taxes and inflation eat into the earning power of your investments.
- Diversifying your portfolio with different types of mutual funds can help you keep up with inflation.
- Consider including growth stock funds, foreign stock funds, and bond funds in a diverse portfolio.
Your Money and the Average Rate of Inflation
As measured by the Consumer Price Index (CPI), the average rate of inflation is roughly 3.00%. Over the last 10 years, it has averaged a little over 2%. If you're feeling like you need to do something with your money, you could put some into a CD that earned 2.00% at your local bank.
After doing some quick math, you figure the difference and see that your money would actually lose 1.00% of its value over the period (2% CD interest - 3% inflation = -1%). In other words, you'd actually fall behind due to inflation.
This still doesn't yet account for taxes owed on your interest income. Taxes would reduce your nominal interest rate (before inflation) to 1.5%, assuming a top federal tax rate of 25%. This would make your inflation-adjusted loss -1.5%! So, in a low-interest rate market, you could save money in a CD but still lose value because of inflation and taxes. You are doing what some call "losing money safely."
The best way for most people to beat inflation is to achieve returns that average more than 3.40%. The most common way for you to do this is to invest in a combination of stock and bond mutual funds.
Beat Inflation With a Portfolio of Mutual Funds
Making a portfolio of mutual funds is similar to building a house. There are many ways to do it. People each have their own strategies, designs, tools, and building materials they prefer. In the end, all structures share some basic features and tend to function the same.
To build a portfolio of mutual funds to grow your money, you must go beyond the sage advice of not putting all of your eggs in one basket. A structure that can stand the test of time needs a smart design and a strong foundation.
The total return of your portfolio is how you beat inflation, not the return of one fund or a few stocks.
You also need a simple combination of mutual funds that can work well for your needs. In this case, simple means a few funds that compliment each other instead of many funds that are almost the same.
Learn How Diversification Really Works
Diversification with mutual funds is more than just putting your eggs into lots of baskets. Many investors make the mistake of thinking that spreading money among several mutual funds means they have a diversified portfolio. However, different doesn't mean diverse. Be sure you have exposure to the various types of mutual funds.
For instance, if you placed $3,000 into the Vanguard 500 Index Fund Admiral Shares, you gain access to Apple, Microsoft, Amazon, and Google stocks. You could then choose a different fund, like the Fidelity 500 Index Fund. You'll receive more shares of Apple, Microsoft, Amazon, and other stocks; however, you're buying more shares of the same stocks that are on the same index.
To achieve more diversity, you might choose the Vanguard 500 and the Vanguard Explorer Fund Investor Shares. The Explorer Fund has its top holdings in health care, industrials, and information technology. The Vanguard 500 focuses more on information technology; however, the holdings are not the same as the 500 fund, but both are focused on growth.
Choose Growth or Foreign Stock Funds
As the name implies, growth stock mutual funds tend to perform best in the mature stages of a market cycle when the economy grows at a healthy rate. The growth plan reflects what corporations, consumers, and investors are all doing at the same time in good times. They expect higher future growth and spend more money to make sure it happens.
Foreign stocks can be risky, so you'll need to make sure you're choosing funds that reflect indexes from countries that are doing well.
When inflation rises, the value of the US dollar may fall. Foreign stock funds can act as a hedge (an asset that works to reduce total losses) as money placed in foreign assets can translate over time into more dollars at home.
Use Inflation-Beating Bond Fund Types
Bond funds can lose value when inflation rises because bond prices move opposite of interest rates. Interest rates tend to rise with inflation. It's a good practice to buy bond funds when inflation is rising because bond prices are falling. Bonds have various terms and ways you can use them to work against inflation.
Rising inflation makes the prices of bonds go down. The longer a maturity a bond has, the farther prices can fall. Therefore, shorter maturities will do better when rates are rising. Keep in mind that short-term bonds may be a good choice for short-term plans when rates are climbing. However, they may not beat inflation in the long run. You may need to get in and out of short-term bonds as things change.
Although the maturities are longer with these funds, no one knows what interest rates and inflation will do. Even the best funds can be wrong from time to time about where interest rates and inflation are headed.
Also known as Treasury Inflation-Protected Securities (TIPS), these bond funds can do well before and during times when inflation rises. Often, the rise coincides with climbing interest rates and growing economies.
Mutual funds are one of the best ways to beat inflation for most investors. Stock mutual funds can provide you with greater long-term returns. This is because they tend to return more than the rate of inflation. However, they have a greater risk of causing you to lose your principal than bonds and bond funds.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.