I’m certain if you watch any news coverage you have heard about inflation. But you might not know what inflation is all about or even how it affects your investments and your money in general. The truth is, inflation can do major damage to your money if you don’t take the proper steps needed.
In this post, I’ll show you how inflation harms your investments and the steps you can take to help protect yourself.
What Is Inflation?
Before we get to the steps to protect yourself, we first need to make sure we have a solid understanding of what inflation is.
Inflation is the increase in price of goods and services over time. For example, a gallon of milk costs $4 today. If inflation is 3%, then next year, that same gallon of milk is going to cost $4.12. Thus you need more money to buy the same goods and services.
Historically inflation averages around 3% per year. And while it rises and falls on its own, each nations central bank works to keep inflation in check. This is done for several reasons.
First, if it rises too quickly, called hyperinflation, the value of money drops dramatically. In other words, it becomes close to worthless. This is what happened in Zimbabwe in 2007.
For years, the government took farms away from some people and gave the land to others who has no business in farming. As a result, food production dropped drastically. Eventually the entire economy was affected and hyperinflation took off.
By 2008, the value of $1 USD was worth $2,621,984,228 Zimbabwe dollars. While it might sound nice to go to Zimbabwe and be a millionaire with your US dollars, think about how difficult it would be to buy milk and bread because of the astronomical prices.
On the flip side of hyperinflation, there is deflation. Here, the cost of goods and services drops to a lower value. The best example here is with technology. When a new 4K television came out it was costing consumers over $5,000. Now you can get the same television for $1,500.
In many cases, consumers make deflation worse because they refuse to spend their money. After all, if prices are falling, why pay for an item today when it will be cheaper tomorrow?
Luckily the central banks in most nations have a firm grip on monetary policy and hyperinflation and deflation are not major concerns.
How Inflation Hurts Your Money
Now we can start talking about how inflation hurts you in your wallet. It does this by making your money worth less. As I showed in the milk example above, each year you are going to need more money to buy the same goods and services.
This is why when it comes to planning for retirement, you are best served investing in the stock market and not putting your money under a mattress or in a bank savings account.
With interest rates so low on savings accounts, you are losing purchasing power. You won’t lose your principal, so most savers are blind to effects of inflation.
For example, if your savings account is paying you 1% interest and you have $1,000 saved, you will have $1,010 next year. If inflation is 3%, then $1,000 worth of goods this year is going to cost you $1,030 next year. You just lost $20 by keeping your money in a savings account.
This is why you need to invest in the stock market. By earning a higher return, historically around 8%, you stay ahead of inflation.
Understand that I am not saying you shouldn’t keep any money in a savings account. These investment vehicles are perfect for short term savings. And as interest rates rise, you won’t be losing as much purchasing power. You could even keep even with inflation.
But for retirement investing, just keeping even with inflation isn’t good enough. You still need to invest in the stock market and earn a higher return.
Now if you want to keep your principal relatively safe but want to earn a higher return than a savings account, what are your options? You have a couple.
- Certificates of Deposit: investing in these will keep your principal safe and allow you to earn a higher return. A good strategy with this is creating a CD ladder.
- Short Term Bonds: investing in these will allow you to earn a higher return and keep your principal somewhat safe. Just understand that your principal could lose value if the price of bonds drop.
- I-Bonds: investing in these will keep your principal safe and since part of the interest you earn is tied to the inflation rate, you won’t be losing purchasing power.
Inflation is the silent killer to savers. While you don’t lose money in savings accounts, you do lose purchasing power. Therefore, while it is important to keep short term cash needs liquid, for long term savings, you need to be investing in the stock market.
This is the best way to beat inflation and ensure that you have enough money to comfortably retire one day.