Investing can help you offset the eroding
effects of inflation by providing a rate of return on your money
that's higher than the rate of inflation.
Cash and cash equivalents generally provide
the least protection against inflation, since their after-tax
returns are typically not enough to outpace it significantly.
Fixed-income investments, such as bonds, provide more inflation
protection, and higher long-term returns provided by stocks and
stock mutual funds may offer the best protection against inflation,
although they can lose money in the short term.
For example, if you put $10,000 in a money market account earning 4% interest, you'd accumulate
$20,300 after 18 years. If inflation averaged 4% per year, your
account would actually be worth $10,150. After taxes, you'd
have considerably less buying power than when you started.
But if you'd invested the money in a portfolio of stocks earning 8% for 18 years — a realistic long-term
return for stocks — you'd have $40,000. After accounting
for inflation you'd still have $20,000, or twice what you
started with.
As
you can see, inflation can have a major impact on your investment
return. If you expect your portfolio to grow, you'll
need to invest in securities that have a good chance of
outpacing inflation.
The unadjusted total return — or increase in share price
plus dividends — on large-company stocks
from 1926 through 2005 was 10.4% compounded annually,
while the inflation-adjusted return was 7.4%.
That means that a dollar invested in large-company
stocks in 1926 would have been worth $2,657.56
before inflation but $241.82 in terms of actual
purchasing power by the end of 2005. During the same period, Treasury bills returned 3.7% annually —
0.7% after accounting for inflation. A dollar
invested in T-bills in 1926 would have been
worth $1.68 by the end of 2005.
