One of the things that many people fail to consider when making financial plans for the future is inflation. It can be difficult to remember to include inflation in one’s calculations because inflation is largely silent. It sort of creeps up on you, commonly manifesting in reduced spending power. It is important not to ignore inflation when making plans for your long term financial future.
What is Inflation?
In the most basic terms, inflation is a rise in prices. Basically, goods and services increase in price over a given period of term. As prices go up, each dollar you have buys less. This means that the value of your dollar decreases over time. $10 bought a lot more in 1970 than it buys now. Consequently, when you retire 20 year from now, $100,000 might not get you as far as it would if you retired today. You can see where the cumulative effects inflation can start to cause problems for your financial situation down the road if you don’t plan ways to counteract inflation.
One of the ways that inflation is measured is through the use of the Consumer Price Index. This is a measure of consumer prices, and their trends. CPI measures the changes, month to month, in the prices included in a basket of services and products. Common items included in the 80,000 products and services that make up the CPI are transportation, clothing, housing, energy, education, food and medical services. And, of course, one has to understand that food and energy are not included in “core” inflation. So, since these are among the most volatile of price changes, they don’t figure in the core inflation rate, so you might see inflation underestimated.
There is no way to be able to completely predict what inflation will be, but there are calculators that can help you estimate how inflation will affect your money in the future. You can also look at historical inflation data to get an idea of what has been happening with inflation in the past and get an idea of what you might be up against in the future.
The main way to help your financial portfolio beat inflation is to invest so that your returns exceed the rate of inflation. If you estimate that inflation will proceed at 3% annually, then you want investments that offer a better return than 3%. One of the reasons that many shun traditional savings accounts with their yields of less than 1% is that, over time, you are actually losing money since your yield won’t beat inflation.
Some of the investments that might be able to help you keep pace with inflation — and maybe even beat it — include:
- TIPS and I-bonds: These are Treasury securities designed to keep pace with inflation so that you do not lose your purchasing power. Because they are backed by the U.S. government, these are generally considered safe.
- Stocks: Stocks have the potential for bigger returns, but they also come with the chance of bigger losses. Some people try to limit their losses with index funds and ETFs.
- Commodities: Generally, commodities do well as the dollar’s value erodes. As commodity prices rise, you can beat inflation — but you have to possess the risk tolerance to deal with the volatility that comes with investing in commodities.
Inflation, especially when combined with taxes, can erode the value of your investment portfolio. Carefully plan ahead, and look for ways to beat inflation when you can. Otherwise, you might find yourself without the funds you need later on.
Miranda is freelance journalist. She specializes in topics related to money, especially personal finance, small business, and investing. You can read more of my writing at Planting Money Seeds.