Inflation is the measure of rising prices, whether for goods such as a gallon of milk or for services such as a mechanic’s hourly rate. That’s a concern for long-term investors, who are likely to find that the dollars they save today can’t purchase as much years or decades from now.
Inflation historically has risen by roughly 3 percent a year.1 At that rate, the purchasing power of a dollar is cut in half in 24 years, meaning you’ll need twice as much income to maintain your standard of living.
In recent years, inflation has grown more slowly—it was just 1.7 percent in 2012.2 Still, many experts believe inflation is set to rise over the intermediate term. “No one knows exactly what will happen, but there will be more inflation eventually,” says James Johannes, professor of finance at the Wisconsin School of Business at the University of Wisconsin-Madison.
The good news: You can take steps to protect your savings against the corrosive effects of higher prices. Those steps include taking advantage of investments that are more likely than others to perform well during periods of rising inflation. These include:
- Stocks. “Over the long run stocks have been a very good inflation hedge,” says Brian Hellmer, director of the Hawk Center for Applied Security Analysis at the Wisconsin School of Business. Historically, stocks have offered greater long-term returns than any other asset class, and have outpaced inflation for every 20-year period since 1926. Maintaining some exposure to stocks can help your portfolio generate enough growth to reduce the impact of inflation.
- Inflation-Protected Securities. As part of your retirement plan you may also wish to include investments that are designed to keep pace with inflation. Treasury Inflation Protected Securities (TIPS) are low-risk government bonds that are designed to keep pace with price increases. The face value of TIPS rises with inflation, which in turn increases the amount the government pays in the form of interest payments. “You’re paid back in inflated dollars, so your money maintains its purchasing power,” says Johannes.
- Commodities and real estate. The price of real estate and commodities tends to rise with inflation. You may want to take advantage by investing a small percentage of your portfolio in mutual funds that specialize in commodities or real estate investment trusts (REITS). Bear in mind that investing in commodities and REITs involves risks. The commodities industries can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Investments in REITs may be affected by economic, legal, or environmental factors that affect property values, rents or occupancy of real estate.
Inflation is all but inevitable, so it’s important to understand the best investments to can help you protect your buying power. Talk to your financial advisor to discuss the strategies to help guard against inflation in your portfolio.