What do I need to know about inflation?

Inflation is an important and somewhat predictable investment risk. Understanding inflation will help you build a portfolio that earns the real investment growth you need to fund your retirement or achieve your other investment goals.

The Impact on Expenses

You can look at inflation from two different angles, but either way it has a big impact on how much money you’ll need to pay for your future expenses.

The chart below shows the effect of 25 years of inflation on purchasing power and prices.

Front of Chart

Inflation on purchasing power and prices

As the chart shows:

One way to look at inflation is as the erosion of purchasing power over time. Have you heard someone say, “$100 doesn’t buy as much as it used to?” They’re right. Assuming 3% inflation, in 25 years $100 will only buy the equivalent of what $47.76 buys today. If you assume 5% inflation, that figure is cut even further to $29.53.

The second way to look at inflation is as the growth of prices. A sweater that you buy today for $100 would cost $209.38 in 25 years, assuming 3% inflation. It may cost as much as $338.64 with 5% inflation. Either way you think about inflation, its impact on prices and purchasing power is significant over time, and your portfolio should be constructed with inflation in mind.

While inflation has averaged 3% annually over the last 25 years, the prices on some items have been climbing even faster. The price of gasoline has risen 5.2% annually over the last 25 years. Depending on what kinds of things you will spend money on in the future, you may have to look at more detailed inflation estimates to fully understand its impact on your expenses.

The Impact on Returns

Because it reduces the purchasing power of your money, inflation dramatically reduces the effective returns on your investments.

The chart below shows the average annual returns of stocks, bonds and cash for the 25-year period from 1989 to 2013, both before and after inflation.

Back of Chart

Inflation dramatically reduces investment returns

As the chart shows:

While the after-inflation return of stocks at 7.4% is very respectable, it’s far lower than the before-inflation return of 10.3%.

On the other hand, the reasonably impressive 3.7% return of cash equivalent investments before inflation is reduced to a fairly meager 1.0% real return once inflation is factored in.

Cash tends to hold its value in nominal returns year after year. But once you factor in inflation, cash has had negative returns in nine of the last 25 years — more negative returns than either stocks or bonds.

Investing involves risk, including possible loss of principal.

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