In simple terms inflation is the rise in cost of goods or services in an economy over time. The chart below shows rates of inflation over certain periods of time. On average we have sustained a 3.22% rate of inflation per year. What does that mean? Well first off at 3.22% inflation prices will double every 20 years, yes double…. Just like compound interest works for us in the investing arena, it works against us in the inflation arena. Also if you are working and not receiving at least a 3.22% raise every year, then you are actually losing money/buying power while still performing the same task. There can be negative inflation also known as deflation, this is where the cost of goods actually go down. During the “Great Recession” prices fell dramatically as the economy weakened and mass unemployment hit America. Not only did the value of properties and farms fall by 50% or more but so did the goods they were producing. One way to monitor inflation is through the Consumer Price Index, just like an Index Fund that we all know and love the Consumer Price Index is an average of staple items that give us an idea of the overall rate of inflation. Like I said earlier, when it comes time for your annual review at work you should be well aware of the inflation rate because if you don’t get at least that amount of a raise you are LOSING money…..
Inflation is one of the main reasons we look to have a balanced portfolio of stocks to bonds. Stocks are shares of companies that can raise prices or cut cost in reaction to inflation or interest rates. Stocks tend to earn a much higher rate of return over time, this allows our savings to grow at a faster rate than inflation. If you kept your money in a savings account over 20 years it would be worth half as much in value. High inflation really hurts the retired because they are not employed and receiving pay raises, they are living off of saved money that now has less purchasing power than it did before. However with the proper ratio of stocks to bonds they should be able to at least keep pace with inflation. So the take away from this story is, if you are still working make sure you are getting at least the annual rate of inflation in your annual pay raises and taking some of that money and investing it in stocks. If you are retired make sure you have a large enough stock allocation in your portfolio to ensure that inflation doesn’t erode your savings.