What is Inflation and How Should it Affect my Investing?

Inflation is an economy-wide, sustained trend of increasing prices from one year to the next. An economic concept, the rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending or purchasing power over time. Inflation also tells investors exactly how much of a return (in percentage terms) their investments need to make for them to maintain their standard of living.

The easiest way to illustrate inflation is through an example. Suppose you can buy a burger for $2 this year and yearly inflation rate is 10%. Theoretically, 10% inflation means that next year the same burger will cost 10% more, or $2.20. So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy as many burgers. However, a one-time jump in the price level caused by a jump in the price of oil or the introduction of a new sales tax is not true inflation, unless it causes wages and other costs to increase into a wage-price spiral. Likewise, a rise in the price of only one product is not in itself inflation, but may just be a relative price change reflecting a decrease in supply for that product. Inflation is ultimately about money growth, and it is a reflection of too much money chasing too few products.

Inflation occurs when the supply of money increases relative to the level of productive output in the economy. Prices tend to rise because more dollars are chasing relatively fewer goods. Another way of stating this phenomenon is that the purchasing power of each money unit declines.

With this idea in mind, investors should try to buy investment products with returns that are equal to or greater than inflation. For example, if ABC stock returned 4% and inflation was 5%, then the real return on investment would be minus 1% (5% - 4%).

Inflation has the same effect on liquid assets as any other type of asset, except that liquid assets tend to appreciate in value less over time. This means that, on net, liquid assets are more vulnerable to the negative impact of inflation. In terms of the broader economy, higher rates of inflation tend to cause individuals and businesses to hold fewer liquid assets.

Illiquid assets are also affected by inflation, but they have a natural defense if they appreciate in value or generate interest. One of the chief reasons most workers place money into stocks, bonds and mutual funds is to keep their savings safe from the effects of inflation. When inflation is high enough, individuals often convert their liquid assets into interest-paying assets, or they spend the liquid assets on consumer goods.

So, you can protect your purchasing power and investment returns (over the long run) by investing in a number of inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These types of investments move with inflation and therefore are immune to inflation risk.

For further reading, please see Inflation-Protected Securities - The Missing Link and our Inflation Tutorial.