Table of Contents
Key Takeaways
- Inflation is when overall prices increase, reducing the purchasing power of money over time.
- Inflation can erode the value of savings, especially those with a fixed payout that may not keep pace with rising prices.
- Investments like stocks and precious metals can potentially keep pace with inflation better than fixed-return options.
- Inflation-indexed investments like TIPS bonds can provide returns that adjust for inflation changes.
- Diversifying your portfolio across asset classes and considering inflation risk is important when investing long-term.
If you follow financial news at all — or even just the nightly news — chances are you've frequently heard experts and economists discussing the economy's inflation rate. While they can make it sound like something to worry about, they don't usually take time to explain the basics, including how inflation can affect your efforts to save and invest. To help straighten things out, we're explaining the potential impact of inflation on your financial plans.
What Is Inflation?
Inflation is when the average prices of goods and services rise over time. Typically driven by supply and demand, prices tend to rise when demand rises or when supply for the good or service falls. As a result, the buying power of an individual dollar decreases when the price of everything has increased. For example, imagine that it costs $100 to buy a bicycle today, and the current inflation rate is 6%: Next year, the price of the bicycle will be $106, assuming that price increases in step with inflation.
In 1965, a single dollar went a lot further, as the median sale price of a house in the U.S. was only $20,200 and a year of undergraduate tuition at the University of Pennsylvania was only $1,570.1,2 As the years went by, wages and prices have increased to push the entire price level up, so the value of a single dollar has gone down. That's inflation in action.
According to the Bureau of Labor Statistics, the inflation rate from January 2022 to January 2023rose 6.4%, but this rate can swing up and down depending on the state of the economy.3
How Can Inflation Impact Savings?
Over time, inflation can reduce the value of your savings, as prices go up in the future. This is most noticeable with cash. If you keep $10,000 under your bed, that money may not be able to buy as much 20 years into the future. While you haven't actually lost money, you end up with a smaller net worth because inflation eats into your purchasing power.
When you keep your money in the bank, you may earn interest, which balances out some of the effects of inflation. When inflation is high, banks typically pay higher interest rates. But once again, your savings may not grow fast enough to completely offset the inflation loss and your purchasing power continues to diminish.
How Can Inflation Impact Investments?
The impact of inflation on investmentsdepends on the investment type. For investments with a set annual return, like regular bonds or bank certificates of deposit, inflation can hurt performance — since you earn the same interest payment each year, it can cut into your earnings. If you receive a payment of $100 per year, for instance, that payment would be worth less and less each year given inflation.
For stocks, inflation can have a mixed impact. Inflation is typically high when the economy is strong. Companies may be selling more, which could help their share price. However, companies will also pay more for wages and raw materials, which hurts their value. Whether inflation will help or hurt a stock can depend on the performance of the company behind it.
On the other hand, investments in certain commodities such as oil, agricultural goods, and precious metals historically do well when inflation is high. While these commodity prices can significantly impact inflation, their rise in price can help to maintain purchasing power as an investment vehicle and are often used as a hedge against inflation. As the value of the dollar goes down, it costs more dollars to buy the same amount of product.
Finally, there are some investments that are indexed for inflation risk. They earn more when inflation goes up and less when inflation goes down, so your total earnings are more stable. Some bonds and annuitiesoffer this feature for an additional cost.
How Can You Plan for Inflation?
Inflation is one reason many people don't put all their money in the bank — over time, that inflation can erode the value of those savings. For that reason, some prefer to keep some of their money in potentially higher-growth investments like stocks or mutual funds, because on average these investments earn more per year than the inflation rate (although they also carry a risk of lower earnings or loss).
You may also want to consider inflation risk as you figure out what kind of asset allocationto have in your portfolio. Fixed investments, like bonds or fixed annuities, can be adversely affected by inflation. To diversify, some investors choose to add gold or inflation-indexed investments such as Treasury Inflation-Protected Securities (TIPS) to provide returns that may adjust for inflation changes. Keep in mind that no diversification or asset allocation strategy can guarantee a profit or protect against a loss in a declining market.
The Bottom Line
Inflation is a market force that is impossible to completely avoid. But by planning for it and putting a strong investment strategy in place, you might be able to help minimize the impact of inflation on your savings and long-term financial plans.
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Sources
- Median Sales Price of Houses Sold for the United States. https://fred.stlouisfed.org/series/MSPUS.
- Tuition and Mandated Fees, Room and Board, and Other Educational Costs at Penn. https://archives.upenn.edu/exhibits/penn-history/tuition/tuition-1960-1969/.
- Consumer Price Index (CPI) News Release. https://www.bls.gov/cpi/news.htm.
As a seasoned financial expert with a deep understanding of economic principles, I want to shed light on the intricate concepts discussed in the provided article about inflation, its impact on savings and investments, and strategies to plan for it effectively.
1. What Is Inflation? Inflation is a persistent increase in the average prices of goods and services over time. This rise in prices is often influenced by the interplay of supply and demand dynamics in the market. The consequence of inflation is a reduction in the purchasing power of money, meaning that a fixed amount of currency buys fewer goods and services as time progresses. The article aptly explains this by using the example of a bicycle's price increasing due to inflation.
2. How Can Inflation Impact Savings? The article rightly points out that inflation can erode the value of savings, particularly when the returns on savings do not keep pace with the rising prices of goods and services. Cash savings are particularly vulnerable, as the purchasing power diminishes over time. Even though banks may offer interest on savings, high inflation rates can outstrip the growth of savings, leading to a net loss in purchasing power.
3. How Can Inflation Impact Investments? The impact of inflation on investments varies depending on the type of investment. Fixed-return options, such as regular bonds or certificates of deposit, may see reduced performance as inflation erodes the real value of their fixed returns. On the other hand, investments in certain commodities like precious metals and commodities historically perform well during periods of high inflation, serving as a hedge against the decreasing value of currency. The article does an excellent job of elucidating the mixed impact of inflation on stocks, emphasizing the importance of assessing individual company performance.
4. How Can You Plan for Inflation? The article provides valuable insights into planning for inflation. Investors often diversify their portfolios across different asset classes to mitigate the impact of inflation. While fixed-return investments may be adversely affected, higher-growth investments like stocks and mutual funds may outpace the average inflation rate, albeit with associated risks. Additionally, inflation-indexed investments, such as Treasury Inflation-Protected Securities (TIPS), can offer returns that adjust for inflation changes, providing a measure of stability in earnings.
5. The Bottom Line The concluding section emphasizes the inevitability of inflation as a market force and encourages readers to develop strong investment strategies to minimize its impact. The importance of diversification and consideration of inflation risk in asset allocation is highlighted, along with the recognition that no strategy can guarantee absolute protection against losses in a declining market.
In summary, this article effectively demystifies the complex concepts surrounding inflation, offering practical insights into its implications for both savings and investments while providing strategic guidance on planning for long-term financial success.
