It is hard not to notice that most things today cost more than they did in the past, with consumer electronics being the main exception. Whether it’s food, gasoline, automobiles or houses, the prices in 2014 are much higher than they were 40, 30 or even five to ten years ago.
This is due to the effects of an economic phenomenon called inflation, which is defined as a sustained increase in the general level of prices for goods and services. The broadest measurement of inflation in the U.S. economy is the Consumer Price Index (CPI), which measures price changes in a market basket of goods that are representative of the overall economy.
You feel the effects of inflation every day when you go to the grocery store or fill up your tank with gas. However, it is also important to realize that inflation will have a significant impact on your long-term saving and investing strategies, including your retirement budget.
This is because over time, inflation erodes the value of your money and reduces your purchasing power. As a result, one dollar in 10, 20 or 30 years will likely buy you less than one dollar buys you today. Over the past century, inflation has risen at an annualized rate of around 3.3 percent a year. If this were to continue over the next three decades, you would need $2.65 to buy the same amount of goods that $1.00 buys you today.
In other words, it is likely that most of the things you buy — groceries, transportation, housing, entertainment, etc. — will cost more than twice as much 30 years from now than they cost today!
Not accounting for inflation is a big mistake many people make when trying to determine how much money they will need to save for retirement. If you are 20 or 30 years away from retirement and mistakenly assume that it will cost you the same amount of money in the future as it does today to buy the things you need, you will probably come up way short in your income projections.
People often do not consider the effects of inflation on their investments. At a minimum, your investments should earn at least as much as the annual rate of inflation. If they aren’t, then you are effectively losing money. So with most cash equivalent investments like savings accounts and CDs now earning less than one percent, you are losing money on any funds in these types of investments when you factor inflation into your overall return.
That is one reason why most financial experts recommend that money being saved for a long-term financial goal like retirement be invested in vehicles that stand a good chance of earning a rate of return that is significantly higher than the rate of inflation. Usually, this means investing retirement savings in equities, preferably via well-diversified stock mutual funds.
Over the long term, stocks have offered returns that are well above the average rate of inflation. For example, since 1928, the average annual return of the S&P 500® Index is 11.5 percent. In other words, the real return (after accounting for the long-term inflation rate of 3.3 percent) of stocks is 8.2 percent. More recently, since 2004, the average annual return of the S&P 500® Index is 9.1 percent, for a real return of 5.8 percent.
In addition, there is an investment security that guarantees returns equal to or exceeding the rate of inflation. Treasury inflation-protected securities (or TIPS) are a special type of Treasury bond in which the principal and coupon payments increase along with the CPI to accommodate increases in inflation.
It is important to note that inflation, if modest, is not a terrible thing. That is because a growing economy will always experience some degree of inflation. Inflation tends to pose the biggest problems for the economy when wages are not growing along with inflation, or when inflation unexpectedly rises at a much faster rate than historical norms, like when the annual inflation rate in the U.S. hit nearly 14 percent back in 1980.
In fact, the opposite of inflation — or deflation, an economic environment where prices are falling — can actually cause more economic problems than inflation. One of the goals of the U.S. Federal Reserve is to maintain just the right level of inflation — one that is not too high or too low.
As a saver and investor, your goal should be to choose investments that will outperform inflation over the long term. It is usually OK to keep short-term money, like an emergency savings fund, in cash equivalents that are not keeping pace with inflation. However, a significant portion of savings earmarked for long-term goals like retirement should usually be invested in stocks and stock mutual funds to increase your potential real return.