When is a dollar not worth a dollar? When inflation eats away at its value.
Inflation is the increase in the costs of goods and services over time. It is typically measured as an annual percentage.
What rising inflation means
As the rate of inflation goes up, your purchasing power goes down. As a result, your cost of living increases. For instance, $100 today has the same purchasing power that $79.131 had 10 years ago.
How inflation affects your investments
It's clear that your investments need to grow at the rate of inflation, or higher, in order to retain your purchasing power. The difference between your investments' total rate of return and the inflation rate is often called the "real rate of return."
Here are a few examples of inflation in action:
- If you invested money at a 5% interest rate and inflation also rises by 5%, you’ll effectively not have earned anything.
- If the inflation for the year is only 2%, you’ll have made a profit of 3% on your investments.
- If your investments are earning 5% and inflation is 7%, you’ll have lost 2%.
Take inflation into account when you choose investments
When you invest for long-term goals, such as retirement, make sure to account for the impact of inflation on your money.
Conservative investments like certificates of deposit and money market funds may provide a margin of safety in a volatile market. They may be OK for short-term financial goals that don't have time to weather market downturns. But they may not offer enough growth to beat inflation over the long term, leaving you with less purchasing power.
Keep in mind that all investing involves market risk, including possible loss of principal. Your investment professional can help you set up a long-term investment plan that takes into account inflation risk.