Inflation is said to be an investor's nemesis. However, a lack of understanding of inflation can be detrimental to an investor's investment portfolio as well.
The factors that lead to an inflationary environment are complex, but you can learn how to invest for inflation if you understand a few basic concepts. There are some methods you can use to invest and hedge (reduce risk) against inflationary economic environments.
Definition and Example of Inflation
Inflation is an economic term that refers to an environment of generally rising prices of goods and services within a particular economy. As general prices rise, the purchasing power of consumers decreases. The measure of inflation over time is referred to as the rate of inflation. Commonly, people may refer to inflation as "the rising cost of living."
For example, prices for many consumer goods are double that of 20 years ago. When you hear your grandparents recall, "A movie and a bag of popcorn only cost a buck-twenty-five when I was your age," they are making an observation about inflation—the rising cost of goods and services over time, and the decrease in the purchasing power of the dollar.
Investing to Stay Ahead of Inflation
Most people invest their savings in investment vehicles such as mutual funds, because they want to use their money to make money. What they don't realize is that by investing, they are also attempting to beat inflation. If you save your money by burying it in jars in your backyard or by stuffing it under your bed mattress, you will lose money to inflation because the cost of living grows while the value of your money does not.
In fact, if your bank account or Certificate of Deposit (CD) does not pay more than the average rise in inflation for that year, you could be losing value.
For example, the average rate of inflation for 2019 was 2.2%. Let's say you place $100 into a CD in January 2019, earning 2.5% annually at your local bank. If you have left that money in the CD for the entire year, it would earn $2.50 in interest, raising your CD's value to $102.50.
The purchasing power of the $102.50 increased by .30% (2.5% - 2.2% = .30%). The $102.50 in the CD has a purchasing power of $102.81 (using the average inflation rate for the one-year period). You have "beaten" inflation with this investment, increasing the value by $0.31.
Try to beat inflation by investing in stocks, funds, or other instruments that return more than the average amount of annual inflation, or the average inflation of the lifetime of the investment.
However, if the CD paid an annual rate of 1.5%, you'd have earned $1.50 (totaling $101.50), and the value would have decreased by 0.7% (1.5% - 2.2% = -0.7%). The purchasing power of the CD would be $100.78. You'd have lost 72 cents to inflation (with a one-year period average inflation rate).
Therefore, in a low-interest-rate environment, you could earn money in a CD but still lose purchasing power because of inflation and taxes—you are doing what can be called "losing money safely."
The best way for most people to beat inflation—to achieve returns averaging more than than the average inflation rate—is to invest in a combination of stock and bond mutual funds that can return more than the average rate of inflation.
Inflation Investment and Hedge Strategies
What most people think when they think of inflation (a gradual increase in the cost of living) is not entirely a bad thing from the perspective of the investor. Inflation can be good. Economists have referred to a healthy balance of inflation and economic growth as a "Goldilocks Economy," because it is a balance that is "just right" for investment, business growth, employment, and consumer activity.
This ideal balance is where the inflation rate is at or below average, and economic growth is slightly above the average inflation rate. This is an environment where stock prices can climb and bond prices are steady because no outside economic stimulus (monetary or fiscal policy) is required.
Generally, stocks are preferred to bonds in inflationary environments because bond prices fall as interest rates rise.
When inflation gets above the Goldilocks level (above 2%), the value of the dollar may begin to fall. Therefore, foreign stock funds can act as an automatic hedge as money invested in foreign currencies is translated into more dollars at home (as long as the exchange rate for the countries invested in are not falling as well).
Categories of mutual funds that may perform well in inflationary environments include treasury inflation-protected securities (TIPS), and bond funds best for rising interest rates—such as short-term bond funds. (Long-term bond funds have more inherent risk than short-term.)
A Caution on Investing for Inflation
Trying to navigate the market and economic conditions with investment strategies is a form of market timing that carries a significant risk of losing value in an investment account. For most investors, building a diversified portfolio of mutual funds is the strategy recommended by professional investors and financial planners to weather most market and economic environments.
Frequently Asked Questions (FAQs)
What causes inflation?
In simplest terms, inflation is just an expression of the ever-fluctuating relationship between supply and demand. When factors push demand up more quickly than supply can adjust, prices rise. Likewise, when there is downward pressure on supply, such as rising production costs, prices will veer upward. These shifts happen for many reasons, including changing consumer confidence, rising wages, government policies, global disasters, and more.
How do I find out the inflation rate?
Inflation can be measured against two major price indices: the consumer price index (CPI) and the personal consumption expenditures (PCE) index. To measure the rate of inflation for a given period, subtract the index price at the beginning of the period from the price at the end, then divide that number by the beginning price. Although the CPI is more widely used to measure inflation, the Federal Reserve bases its inflation metric on the PCE, and it uses several variations to measure different types of inflation.
Why is inflation important?
Inflation affects the economy in many significant ways. Rising prices mean the value of the dollar is decreasing for consumers and businesses alike. The IRS bases tax rates and brackets on the rate of inflation. On the other hand, a low rate of inflation may indicate that the economy is stagnant. Although some sectors and individuals are more insulated from the effects of inflation, it impacts everyone in some way. That's why many policies of the Federal Reserve are meant to control the rate of inflation.