Investing Basics: What Is Inflation?

Inflation, a good thing or a bad thing? The answer, strangely enough, is “both” and how you react to inflation can deeply affect your retirement investment planning.

First of all, what is inflation? Inflation is nothing more than rising prices. We all know intuitively that things will cost more in the future. The price of energy and food goes up and down pretty quickly, but the average price for most things steadily rises over time.

How fast is the issue. Economists want “healthy” inflation of about 2% and generally accept long-term inflation of perhaps 3%.

Slowly but steadily rising prices are a sign of a growing economy. It signals demand for goods and services that slightly exceeds the available supply.

Over time, demand can slip. When it falls consistently, we tend to worry that a recession has begun, that the economy itself is shrinking.

The opposite can happen, too. Demand can outpace supply dramatically, causing prices to rise more quickly than expected.

The Federal Reserve has tools at its disposal to tamp down inflation or, as in recent years, attempt to keep inflation rising even if the economy is weak. For the retirement investor, these short-run moves by the Fed aren’t important.

What matters is finding investments that provide a return that exceeds inflation over many years. The return you get from the stock market might be 9%, but subtract 3% inflation and your actual purchasing power is growing by 6%.

That’s called “real return,” and it’s the goal of retirement investors to keep that number positive. Your money is likely to double in value — that is, to compound — so long as the real return is high enough. A long run of below-par investment returns isn’t a help if inflation is eating the value of that money along the way, too.

What is inflation risk?

When financial advisors talk about risk, one of the factors that they include is inflation risk, put simply the risk that inflation will grow faster than your expected investment returns. In that scenario your savings actually lose value, despite being invested.

Investors offset inflation risk by making sure that their portfolios include a healthy dollop of growth investments, such as common stocks. While stocks are more volatile than bonds or real estate, they do tend to grow faster than inflation over the years.

A retirement portfolio balances the risk of loss from stock investing against the equally complex risk of purchasing-power loss due to inflation. Keep both risks in check is the job of a well-designed portfolio.

Diversification and rebalancing are the final pieces of the puzzle. Inflation is inevitable and, to a degree, desirable for the economy at large. Just don’t let it become an unacceptable risk to your long-term retirement planning.