What is inflation and why you should care?
Inflation occurs when there is more money circulating than there are goods and services to buy. The process is like trying to attend a sold-out concert at the last minute; there is more demand for tickets than there are tickets to go around. As a result, tickets may trade hands for far more than their stated prices. When there is a lot of demand for goods and services, their prices usually go up. The law of supply and demand produces price inflation.

Inflation cuts purchasing power
When some people say, “I’m not an investor,” it’s often because they worry about the potential for loss. It’s true that investing involves risk as well as reward. However, there is also another type of loss to be aware of: the loss of purchasing power.

Inflation is painful enough when you experience a sharp jump in prices. However, the bigger problem with inflation is not just the immediate impact, but its effects over time. Because of inflation, each dollar you have saved will buy less and less as time goes on. At 3% annual inflation, something that costs $100 today would cost $181 in 20 years.

How is inflation measured?

• The Consumer Price Index (CPI): The most widely quoted inflation measure tracks the price change from month to month of a basket of goods and services used by the average consumer.
• Personal Consumption Expenditures (PCE): This statistic adjusts for the fact that when the prices of some items rise, people and businesses may substitute others; for example, if steel prices are high, a car maker might make some parts from other substances. When setting target interest rates, the Federal Reserve Board takes into account so-called core PCE (which excludes food and energy because their prices can vary dramatically from month to month).
• Producer Price Index (PPI): This measures inflation from the standpoint of sellers rather than consumers.

How high is high?
The average inflation rate as measured by the CPI has been roughly 3% since 1914. Since the early 1980s, it has remained relatively stable between 1.6% – 4.6% annually. However, the inflation rate has varied much more dramatically in the past. During the Great Depression, it often ran in the negative numbers. The country actually experienced deflation in 1921, when the inflation rate was -10.8%.

On the other hand, inflation also has been much higher than most of us have ever experienced. Just prior to 1920, the U.S. suffered from four back-to-back years of double-digit inflation. The worst was in 1918, when prices rose by an astounding 20.4%. More recently, in 1979 the annual inflation rate hit 13.3%, driven at least in part by higher gas prices.

How can you fight the effects of inflation?
Inflation is one of the reasons people–especially those in their 20s and 30s–are often surprised by the amount they will need to save for their retirement. Inflation pushes future costs higher: as a result, the nest egg needed to produce the income you want would need to be bigger.

There are several ways to help combat the ravages of inflation on the value of your saving

Invest to try to outpace inflation
You should own at least some investments whose potential return exceeds the inflation rate. A portfolio that earns 2% when inflation is 3% actually loses purchasing power each year. Though past performance is no guarantee of future results, stocks historically have provided higher long-term total returns than cash alternatives or bonds. However, that potential for greater returns comes with greater risk of volatility and potential for loss. You can lose part or all of the money you invest in a stock. Because of that volatility, stock investments may not be appropriate for money you count on to be available in the short term. You will need to think about whether you have the financial and emotional ability to ride out those ups and downs as you try for greater returns.

Bonds can also help, but since 1926, their inflation-adjusted return has been less than that of stocks. Treasury Inflation Protected Securities (TIPS), which are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, guarantee that your return will keep pace with inflation. The principal is automatically adjusted every six months to reflect increases or decreases in the CPI; as long as you hold a TIPS to maturity, the dollar amount of its principal will never be less than the initial amount.

Diversifying your portfolio–spreading your assets across a variety of investments that may respond differently to market conditions–is one way to help manage inflation risk. However, diversification does not guarantee a profit or ensure against a loss. Examples of investments include:

• S. stocks (growth/value, income-producing, large/midcap/small)
• S. bonds (various maturities, taxable/tax-free)
• Real estate (U.S. stocks/REITS, international stocks/REITS, land holdings, commercial real estate)
• Commodities (stocks and commodity futures)
• Precious metals (stocks and bullion)
• International stocks (developed/emerging markets)
• International bonds (varying maturities)
• Alternative investments (private equity, hedge funds, natural resources, and collectibles)
• Cash/cash alternatives (money market funds, CDs, money-market accounts)

Save more
If you are saving the same amount each year, you are not really saving the same amount; you are saving that dollar figure minus what you have lost in purchasing power to inflation. Consider increasing the amount you save each year by at least the rate of inflation if you want to keep a constant savings rate.

Consider paying off credit card debt
When inflation goes up, interest rates typically follow. You may suddenly find that purchases not only cost more when you check out; they also cost more over time if you finance them and pay interest on that amount. Factor interest costs into any credit card purchase, especially if rates are rising.

However, inflation is not bad for all debt. If you have a fixed-rate mortgage on your house, the mortgage payments may have seemed huge when you first took out the loan. However, as your income and other expenses increase over time, those payments will probably represent a lower percentage of your costs. Also, because inflation tends to reduce the value of each dollar, payments made 10 years from now would be made in dollars with less buying power.

Inflation and bonds: the ups and downs
Inflation has an impact on most securities, but it can particularly affect the value of your bonds. Why? Because bond yields are closely tied to interest rates, and when interest rates and bond yields rise, bond prices fall.

When the Federal Reserve Board gets concerned that the rate of inflation is rising, it may decide to raise its target interest rate. That makes borrowing money more expensive, which in turn tends to slow the economy. When the Fed raises its rate, bond yields typically rise as well. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds.

When yields rise, bond prices typically fall. That is why bond prices can drop even though the economy may be growing. An overheated economy can lead to inflation, and investors often begin to worry that the Fed will raise interest rates, which hurts bond prices.

All bond investments are not alike
Inflation and interest rate changes do not affect all bonds equally. Under normal conditions, short-term interest rates may reflect the effects of any Fed action most immediately, but longer-term bonds likely will see the greatest price changes.

Also, a portfolio of bonds may be affected somewhat differently than an individual bond. For example, a portfolio manager may be able to minimize the impact of rate changes, altering the portfolio’s duration by adjusting the mix of long-term and short-term bonds.

Inflation does not retire when you do
The need to outpace inflation does not end at retirement; in fact, it becomes even more important. If you are living on a fixed income, you need to make sure your investing strategy takes inflation into account. Otherwise, you may have less buying power in the later years of your retirement because your income does not stretch as far.

Your savings may need to last longer than you think
Gains in life expectancy have been dramatic. According to the National Center for Health Statistics, people today can expect to live more than 30 years longer than they did a century ago. Individuals who reached age 65 in 1950 could expect to live an average of 14 years more, to age 79; now a 65-year-old might expect to live for roughly an additional 19 years. Assuming inflation continues to increase over that time, the income you will need will continue to grow each year. That means you will need to think carefully about how to structure your portfolio to provide an appropriate withdrawal rate, especially in the early years of retirement.

Adjusting withdrawals for inflation
Inflation is the reason that the rate at which you take money out of your portfolio is so important. A simple example illustrates the problem. If a $1 million portfolio is invested in an account that yields 5%, it provides $50,000 of annual income. But if annual inflation runs at a 3% rate, then more income–$51,500–would be needed the next year to preserve purchasing power. Since the account provides only $50,000 of income, $1,500 must also be withdrawn from the principal to meet retirement expenses. That principal reduction, in turn, reduces the portfolio’s ability to produce income the following year. In a straight linear model, the principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals.

Invest some money for growth
Some retirees put all their investments into bonds when they retire, only to find that doing so does not account for the impact of inflation. If you are fairly certain that your planned withdrawal rate will leave you with a comfortable financial cushion and it’s unlikely you will spend down your entire nest egg in retirement. However, if you want to try to help your income–no matter how large or small–at least keep up with inflation, consider including a growth component in your portfolio.