If you went to business school, work in financial services or just take an interest in economics, you have heard the term ‘inflation’ before. If you haven’t, don’t worry, by the end of this post you will be well versed in the course Inflation 101.
We’ll start by answering the question, what is inflation? Inflation is a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services. Inflation can be measured in a variety of ways, but our focus will be on the Consumer Price Index (CPI). This index uses the weighted average price of a basket of primary goods and services that consumers need. Changes in CPI are published monthly by the Bureau of Labor and Statistics, and reflect changes to the prices of each item in the basket. A good example I found on Investopedia is the price change in coffee over a 50 year period. I created a table to show the change in price to illustrate the effects of inflation.
|Change in price over previous period||80.00%||66.67%||33.33%||25.00%||27.20%|
|Change over total period||536.00%|
Notice while the year-over-year change is not substantial, the change from the beginning of the period to the end of the period is quite drastic. This is a simplified version of how, over time your money is losing value as good and services become more expensive.
Let’s talk about how inflation affects your money. Consider the January 2021 CPI which is 1.4%. On a seasonally adjusted basis, over the last 12 months the weighted average change of consumer goods and services increased 1.4%. So, if your grandmother gifted you $100 12 months ago and you decided to deposit the gift to your checking account, well your $100 is now worth $98.60. Inflation is LITERALLY reducing the value of your money and the longer you hold it the more value it may lose. Thankfully, there are several low-risk ways in which you can protect your cash from inflation.
These are a type of bond issued by the US government that provides protection against inflation. What makes these assets great tools against inflation is the principal of TIPS rise with inflation and falls with deflation. Therefore, if inflation occurs, you will receive an adjusted principal amount.
Modeled after mutual funds, a REIT is an investment trust that owns, operates or finances income generating real estate. REITs provide protection because rents and real estate values usually rise with inflation. Ever notice how your rent increases by 2-5% every year? REITs can, therefore, be used as an asset that provides some inflation protection for your money.
3. Index Funds
Index funds are mutual funds that track major indexes. For example, Vanguard has a fund that tracks the S&P 500 index. That is, the fund is composed of the same companies at relatively similar weighting as the actual S&P 500 index. Mutual funds are also offered as electronically traded funds (ETFs) that are traded like stocks and are valued based on the net value of the underlying fund. In the last 12 months the S&P 500 index rose ~16%. That is 14.6% above inflation. This is a great vehicle that I use to protect my money from inflation and is a great way to get into investing for those who are not financially savvy.
Special thanks to Jhenine for editing this post!