Quick, check your pockets—do you have enough loose change to buy a coffee? Sweet, it looks like it’s just enough to get a tall half-sweet soy caramel macchiato! But wait, wasn’t that brew almost half a dollar cheaper the last time you ordered one? That’s weird. So what about one, five, or ten years from now—do you think the same handful of coins would still be able to get you the same drink, or would you have to settle for (gasp!) a small, non-fat latte with caramel drizzle? Wh-what’s going on? Got that coffee now? Okay, sip slowly and read on about a little thing called inflation.
What is inflation?
To gain a full understanding of the issues behind inflation and build effective investment strategies to contain its effects, we must first develop an understanding of what it is. Inflation is essentially a measure of how prices in an economy increase over time, or inversely, it is the rate at which the purchasing power of a given currency gradually decreases.
The rate of inflation is important for investors or anyone seeking to better plan out their personal finances because it also leads to increased costs of living and may hinder a nation’s economic growth.
So in terms of what we may have all seen ourselves, inflation is the percentage of how the value of a single dollar constantly buys less than it did previously (although prices are also affected by the laws of supply and demand).
Central banks try to keep inflation within manageable levels by easing or tightening the money supply and implementing responsible monetary policy. Interest rates are lowered to avoid inflation at the expense of slowing growth, while raising rates can stimulate spending and investment activity at the risk of higher inflation.
What is the relationship between investments and inflation?
Ideally, the effects of inflation on a general population should be offset by a corresponding proportionate increase in salaries and wages. However, this is not always the case, especially for people who rely on a fixed income. Consumers therefore need to understand and seek alternative methods to mitigate the effects of inflation on their daily lives.
However, as you might already know, not all investments are created equal in terms of risks, returns, and maturity timelines. Inflation tends to stealthily eat into returns on investment, meaning that for example, earning 2% interest in a 3% inflation environment actually produced a negative adjusted result.
As such, investors should be wise about inflation and set investment targets accordingly.
How can investors mitigate its effects?
Perhaps the safest and most common way to grow the value of your money is through savings accounts, although interest rates on these generally lag behind the pace of inflation.
So as in the example above, even with the power of compound interest, a savings account with an annual yield of 2% can only go so far toward shielding you from the effects of inflation (assuming you can also make regular deposits and resist spending your balances). In this sense, interest-bearing accounts can be seen more as VIP parking for your money than practical investment channels.
A far more liquid and potentially higher-yield (read: attractive) investment channel that you can easily access these days is the stock market. Historically, well-diversified and responsibly-managed investment portfolios have returned 10% over time, and potentially much more if you happen to chance upon a set of particularly high-performing stocks.
While stock trading is inherently a risky endeavor, there are quite a few smart strategies to manage risk, such as diversification and timing the purchase and sale of stock. Luckily for you, these are all subjects that you can easily learn more about through Academy!