What is inflation and Inflation is a term that's used to describe an increase in prices for goods and services. If the cost of your grocery list increases by more than 1% over the course of a year, then that can be considered inflation. In investing, inflation refers to a rise in price levels across a range of different asset classes.
For example, if stocks go up by 5%, bonds rise 3% and the dollar gains 2% against foreign currencies but loses 4% to inflation—the investor is still left with a positive return overall because the "real" returns of bonds and cash exceeded the rate at which prices increased on average (in this case, 2%). Inflation is one way—and perhaps the most common way—that investors can lose purchasing power. In a nutshell, investing in a way that's designed to keep pace with or exceed inflation means investing in a way that protects wealth from the eroding effects of rising prices.
Some forms of investing can help boost returns to make up for the effects inflation has on your purchasing power. To get an idea of how inflation-protected investing works, let's look at two hypothetical examples.
1) For instance, if you had $100,000 in cash and wanted to "keep up with inflation," then you'd need to earn an annual return of about 1% each year just to maintain your buying power over time (assuming that another 1% goes toward covering taxes). Otherwise, if prices rose by 3%, then the value of your investments would be cut down to $96,000 after a year—effectively costing you $4,000 in lost spending money.
If you don't want to worry about investing in a way that keeps up with inflation, you can just invest in a fund that tracks the CPI. These "inflation-linked" investments are designed to offer positive returns regardless of whether inflation is low, moderate or high. In return for investing in a product like this, you'll likely have to settle for lower average rates of return since these funds tend not to provide outsize returns.
2) In our second hypothetical example, let's say your goal is to earn more than the rate of inflation each year—perhaps 3% instead of 1%. If prices rose by 3%, then your money would still be worth $100,000 after a 12-month period—but if inflation were 5%, then your investment would essentially lose 2% from its "purchasing power."
To get an inflation-beating return, you have to do two things: invest in riskier assets that can generate higher returns, and reduce your investing costs. The more you're willing to gamble on the stock market, the more the potential reward will outweigh the risks—but you'll likely need a larger starting sum of money if investing in any kind of risky asset class is going to make sense.
The less someone pays for investing fees (also known as investing expenses), the better their chances are at earning inflation-beating returns over time. Operating costs eat into your bottom line—and while it's impossible for most investors to completely eliminate these fees, there are some steps people can take to reduce them: they can minimize their investing costs by investing in mutual funds and ETFs rather than paying for expensive, actively-managed services; they can buy low-cost index funds instead of pricier alternatives; and they can reinvest dividends as opposed to cashing them out (which saves on taxes as well).
At the end of the day, investing is about keeping up with inflation or investing in a way that beats it. It's tough to beat inflation over time if you're only willing to invest in products offering returns that keep pace with inflation. To get an edge on inflation, investors have to step outside of "average" investing strategies—they have to be willing to take on more risk or pay lower prices across the board.
In the United States, inflation reached record levels during the 1970s. In 1978, inflation was at its peak—it hit 14%. This means that everything from gas prices to food to housing costs were extremely high during this period. With such a high inflation rate year after year, investing in real estate made sense because investing in something with low rates of return would not allow investors to keep pace with inflation; however, investing in real estate could yield returns closer to inflation without losing any money in the process. While there might be some minor expenses associated with investing in property or need for repairs on an annual basis, when investing in real estate there never seems like there is a negative return on investment. This allows investing in property to come out ahead of investing in low rate of return assets like stocks during times of inflation.
Real estate investing can be one of the most successful inflation hedges available today, even in unstable markets like what we are currently seeing now. The saying “those who fail to learn from history are doomed to repeat it” was never more accurate than here; this article will go over some examples of investing in real estate during previous times of inflation and give advice on how you can best avoid the pitfalls that many investors fell into when investing in real estate during those times. Investing in real estate can be one way to hedge against inflation, and investing in real estate is a great option if you need immediate returns on your money.
