Ever feel like your money is not going as far as it used to? Do not worry, you are not imagining it. You can blame inflation. Inflation is the rising price of goods and services over time. This rise impacts your purchasing power.
There are two main causes of inflation:
- Demand Pull Inflation and Cost Push Inflation. Demand Pull Inflation occurs when the demand for a product increases, but the supply remains the same. This in turn pulls up prices.
- Cost Push Inflation occurs when supply is limited for some reason, but demand remains the same. This pushes up the price of a service or good.
Though it can be discouraging to think that inflation is eating away at the value of your assets, economists consider a small amount of inflation indicative of a healthy economy. Inflation encourages consumer spending and corporate productivity.
What You Need to Know
Money left sitting in cash is the most vulnerable to inflation risk. For example, if inflation increases by 5% a dollar left in cash is now worth $0.95. In this scenario, Money has been lost by simply allowing the cash to sit idle. Luckily, there are some tried and true strategies investors employ to keep one step ahead of inflation:
- Commodities – Commodities are naturally occurring resources and have historically acted as an effective hedge against inflation. These resources include asset classes such as: metals (gold, silver), energy (oil), and agriculture. You can purchase physical commodities, but that is usually unrealistic for most investors. Instead, investors can purchase commodities via future contracts on an exchange.
- Real Estate – Real estate income comes from rental properties and has proved to be one the best ways to hedge your portfolio against inflation. Inflation causes real estate values to climb which in turn allows landlords to charge more to rent their properties. This strategy may be utilized by owning a physical building and renting it out or by investing in a Real Estate Investment Trust (REIT). A REIT is a company that owns and operates income producing real estate. Investors can invest in the REIT and share in the companies profits in the form of dividends.
- Stocks/Mutual Funds/ETFs – Investing is the simplest way to protect your assets from inflation. Stocks, Mutual funds, and ETFs are all accessible, easy to understand options. The idea is that allowing your money to grow in the stock market protects it from inflation risk because (hopefully), your rate of return exceeds the rate of inflation.
- Diversification – Inflation does not affect all industries and assets classes in the same way, at the same time. That is why diversifying your portfolio is one of the best things you can do to protect your savings against inflation. A financial advisor can help you create a portfolio that is suitable to your risk tolerance and investment goals while ensuring you are not overexposed to any one area of risk.
The Bottom Line
Inflation is a very real risk to any portfolio. It is important to work closely with an investment professional to develop and utilize strategies to protect your hard-earned savings.