Inflation Risk

Inflation Risk — How being too safe can be risky

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Inflation makes things cost more than they used to. It’s why the average cost of a new car in 1972 was about $3,000 and today it’s about $28,000. If inflation averages 3% a year, in 30 years, groceries that cost $100 today will cost $250. As a smart investor, your goal should be to choose investments that don’t just keep pace with inflation, but have the potential to exceed it.

Get real with your returns

You don’t have to be a math whiz to see that your investments need to earn more than the average inflation rate to actually grow your purchasing power1. To understand the real return on your investment, you need to subtract the inflation rate from the investment growth rate. For example, if you get a 5% after tax return and the inflation rate is 3%, your real return is 2%. Inflation risk isn’t the risk of inflation; it’s the risk that inflation will be higher than you anticipated.

Choose investments that not only keep pace with inflation, but exceed it.

Pump up your purchasing power

One potential way to reduce your inflation risk is to increase your market risk by adding stocks to your portfolio. Although past performance is not a guarantee of future results, historically, stocks often provide returns higher than the average inflation rate. Having a percentage of your retirement savings in equity-based investments could help to increase your purchasing power and offset the effects of inflation. Depending on your goals and time horizon, diversifying into other investment options may also help.

Find your balance

Playing it too safe by investing only in investments with consistent, low returns, can actually be a very risky strategy due to inflation. Balancing other types of risk with an appropriate asset allocation strategy could help you beat inflation over the long haul.

1 Purchasing power is the amount of goods or services you can buy with a unit of currency, say a dollar. If your dollar bought more goods 10 years ago than it does today, your purchasing power has declined.

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