Twenty cents for a gallon of milk; 10 cents for a loaf of bread. A new house for $10,000. A new car for $2,000. These prices may seem like a pipe dream but this was the reality in the 1940s. Prices are much higher today because of inflation – the rate the prices of goods and services rise and, as a result, purchasing power falls. Today, after 70 years of inflation, you’ll need about $3.50 to buy a gallon of milk and $30,000 to purchase the average new car.
You may have noticed prices rising over time but have you ever considered how inflation affects your savings and investments? Stocks are considered risky due to market volatility, but that risk is often tied to a strong return. On the other hand, the commonly low return on assets such as savings accounts, CDs, and bonds makes them risky in a different way. It’s called inflation risk: the possibility that inflation will effectively diminish the return of an investment.
Let’s take a look at an example. If you invest $1,000 in a CD in 2014 and get a 2% return annually, you would have about $1,060 in 2017. However, if the rate of inflation during that time is 3%, you would need $1,090 in 2017 to buy something that cost $1,000 in 2014. In this scenario, because the rate of inflation is higher than the rate of return, your investment would actually buy less in three years than it would today, despite having more actual dollars.
This is one of the reasons we encourage diversifying your investments in a portfolio tailored to your financial goals, time horizon, and risk tolerance. A portfolio containing stocks, bonds, and other assets across various different sectors has the potential to earn a rate of return higher than the rate of inflation.
What does your portfolio look like? Is it designed to protect your investments from inflation and other risks? Is it customized to reach your financial goals in a timely manner? Protecting your investments from inflation risk may not be able to bring back the 10 cent loaf of bread, but it can help you be ready for whatever it will cost in the future.