Learn How to Beat Inflation With Your Investments

Investment Strategies to Beat Inflation

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Without really knowing it, most people are investing to beat inflation, which is the rise in cost of goods and services over time. If you are saving for a long-term goal, such as retirement, and you're not earning above the average rate of inflation, your nest egg is not growing; it's either staying the same or shrinking. Find out how to beat inflation with mutual funds.

Your Money and the Average Rate of Inflation

The average historical rate of inflation, as measured by the Consumer Price Index (CPI) is roughly 3.00%. Let's say you are feeling financially responsible and put your hard-earned cash into a CD, earning 2.00%, at the local bank. Doing some quick math, you can calculate the difference (3.00 - 2.00 = 1.00) and see that you are still losing to inflation by 1.00%.

This doesn't even factor in the effect of taxes on your savings, which would reduce your real rate of interest (after inflation and taxes) to roughly 0.10%, assuming a top federal tax rate of 25%. Therefore, in a low-interest rate environment, you could save money in a CD but still value because of inflation and taxes -- you are doing what I call "losing money safely." The best way for most people to beat inflation--to achieve returns averaging more than 3.40%—is to invest in some combination of stock and bond mutual funds.

Beat Inflation With a Portfolio of Mutual Funds

Building a portfolio of mutual funds is similar to building a house: There are many different kinds of strategies, designs, tools and building materials; but each structure shares some basic features.

To build the best portfolio of mutual funds you must go beyond the sage advice, "Don’t put all your eggs in one basket:" A structure that can stand the test of time requires a smart design, a strong foundation and a simple combination of mutual funds that work well for your needs.

Understand the Basics of Diversification With Mutual Funds

Diversification with mutual funds is more than just putting your eggs into different baskets. Many investors make the mistake of thinking that spreading money among several mutual funds means they have an adequately diversified portfolio. However, different does not mean diverse. Be sure you have exposure to the different categories of mutual funds.

Beat Inflation With Growth Stock Funds

As the name implies, growth stock mutual funds typically perform best in the mature stages, such as inflationary periods, of a market cycle when the economy is growing at a healthy rate. The growth strategy reflects what corporations, consumers, and investors are all doing simultaneously in healthy economies--gaining increasingly higher expectations of future growth and spending more money to do it.

Beat Inflation With Foreign Stock Funds

When inflation intensifies, the value of the US dollar may fall. Therefore foreign stock funds can act as an automatic hedge as money invested in foreign currencies is translated into more dollars at home.

Best Bond Fund Types For Rising Interest Rates and Inflation

Bond funds can lose value in inflationary environments because bond prices move in opposite direction as interest rates, which rise along with inflation. However, a wise investor will still diversify with bond funds and will, therefore, find the best bond funds for rising interest rates:

  • Short-term Bonds: Rising interest rates make prices of bonds go down but the longer the maturity, the further prices will fall. Therefore, shorter maturities will do better in a rising interest rate environment. Keep in mind that, although short-term bonds may be wise for short-term investment objectives in a rising rate environment, they may not beat inflation in the long run.
  • Intermediate-term Bonds: Although the maturities are longer with these funds, no investor really knows what interest rates and inflation will do. For example, even the best fund managers can be wrong from time to time on the direction of interest rates and inflation in the short term.
  • Inflation Protected Bonds: Also known as Treasury Inflation-Protected Securities (TIPS), these bond funds can do well just before and during inflationary environments, which often coincide with rising interest rates and growing economies.

Consider a "Ladder" Approach to Certificates of Deposit (CD)

When interest rates are rising, investors wanting the relative safety of CD's may consider a ladder approach, which means new CD's with short redemption periods, such as one year or less, and are purchased periodically, such as once per month or once every few months, to capture the higher rates as they rise. The idea is to climb the figurative ladder progressively higher. After several months, your newest CD will likely receive the highest rate. Once interest rates appear to be stabilizing, you may consider locking in the higher rates for longer holding periods.

Keep in mind, however, that CDs will usually match the current rate of inflation, not beat it. And unless your CD is held in an individual retirement account (IRA), you'll owe taxes on the CD's interest.

Bottom Line

Mutual funds are generally the ideal investment type to beat inflation for the average investor. Stock mutual funds generally provide greater long-term returns that the average rate of inflation. However, stocks have greater market risk (risk of losing principal investment) than bonds and bond funds.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.