Inflation is a concept that is very easy for investors to grasp: at its core, inflation is simply an annualized measure of the increase in the cost of living. As such, anyone who is investing for their retirement would be well-served to keep inflation rates at the forefront of their thoughts when making investment decisions; any retirement-minded investor who fails to, does so at their own peril. Inflation can significantly erode investment return, in many cases prohibiting retirees from maintaining their accustomed standard of living. It’s the bogeyman under the bed which, when combined with taxes, can traumatize retirees throughout their golden years.
Although we’ve been lucky enough in the United States to have enjoyed relatively low inflation in the new millennium, there’s no guarantee that this will remain the case. Thus, a prudent investor will factor inflation into their investment planning. One simple way to hedge against inflation is to make sure that your investment portfolio is sufficiently diversified, without relying too heavily either on a disproportionate percentage of cash or cash investments (which will immediately decrease in value in direct, inverse proportion to the prevailing inflation rate) or on fixed income securities, which react similarly to increases in the inflation rate. Long-term, low-yielding securities should not command too prominent a place in your portfolio, and you should diversify further by including a percentage of stocks so that you have some short-term assets in your arsenal capable of providing a return higher than the inflation rate. The trick is to find the balance between conservative, stable investments and shorter-term, higher yield assets.
The effect of inflation on investment profits is immediate and unavoidable. If the inflation rate is 2% and your portfolio grew by 10%, in terms of real purchasing power your portfolio has effectively only grown by 8%. In this example, thanks to inflation, you’ve lost 20% of your profit in the blink of an eye…and still must pay taxes on your capital gain. You can only mitigate this by finding investments that will provide a consistently high return, and by ensuring that your annual return on investment remains higher than the adjusted inflation rate, so that you do not lose purchasing power. Don’t build an investment portfolio that relies too heavily on long-term, low-yielding assets. Include assets that are pegged to inflation rates, such as treasury bonds and annuities, in your portfolio as a hedge not only against inflation, but against increases in the rate of inflation.
Inflation is a fact of life. All prices rise over time; your job, as an investor, is to reduce its impact by beating the rate at which those prices rise. Diversify your portfolio in terms of asset class, risk and tenor so that it is comprised of a mix of financial products and instruments that provide you with a return at least equal to the adjusted rate of inflation, if not more, and remain informed about interest rates and trends so that you can spot when a rise in inflation rates is looming. As is true with all aspects of investing, when it comes to inflation, knowledge is power.