Inflation is a measure of average price changes of goods and services over a period of time expressed as a percentage. The statement “inflation was 3% last year” means that cost of living for the average person increased by 3% for that year.
How is it measured?
Inflation is usually measured using the [consumer price index (CPI)] as calculated by the Bureau of Labor Statistics. This index tracks the price change of a standard basket of goods and services which is measured in different areas of the country over specific periods of time. It is normally expressed as a percentage increase or decrease.
Why does it matter for investing?
Inflation is a very important factor when planning your retirement investing strategy. As discussed in [this post on investment real returns], it doesn’t matter how well your investments perform if they don’t exceed the inflation rate over the long term.
If you are creating an investment portfolio then you should consider that certain types of investments (asset classes) have a better chance of beating inflation than others.
- Stocks – this includes any kind of mutual fund, index fund, ETF that contains stocks. Over the long term stocks have performed significantly better than inflation.
- Bonds – these include any kind of bond mutual funds, index funds or ETFs. Bonds tend to beat inflation but not by as much as stocks.
- TIPs – inflation protected bonds will do slightly better than inflation.
- Cash – this includes high-interest savings accounts and certificates of deposits. These investments typically do not keep up to inflation over the long term.
Please keep in mind that stocks, bonds, cash and inflation can all be highly variable over periods of time (ie 30 years or less) so different asset classes will outperform at different times. This is why a diversified portfolio is important.
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