Inflation 101: How It Works and What You Can Do about ItSubmitted by Bernhardt Wealth Management on April 16th, 2018
Though mostly out of sight since the financial crisis and Great Recession of 2007-2009, inflation has been in the news again recently, especially since fears of inflation were blamed for the stock market’s dramatic selloff in February 2018. But what is inflation, exactly? And why does the stock market seem so scared of it? Perhaps most important; is there anything you can do to protect yourself and your assets from the effects of inflation?
In the simplest terms, inflation occurs in an economy when money is too plentiful. According to basic supply and demand, if a thing is too common, it has little value. For example, no one charges a price for air to breathe, because breathable air--though incalculably precious in sustaining life--is very common. Similarly, when currency becomes too common, it loses value. Over time, more of it is required to buy the same thing. A famous example of extreme inflation (hyperinflation) is in post-WWI Germany, when inflation became so rampant that people in Berlin were using the money printed by the Weimar Republic to paper their walls, because it was almost worthless for anything else. In Venezuela, as recently as 2012, thieves refused to steal the nation’s currency, because it had so little value.
In less extreme terms, we see inflation at work in the prices of food and other goods. If you have ever looked at an old restaurant menu from the 1800s or even the early 1900s, you have noticed that you could buy a cup of coffee for a nickel, and you could eat a meal for fifty cents or less. The higher prices we now pay for common things like food, housing, transportation, and entertainment are the result of inflation over time.
It is important to remember that inflation is not always bad. As long as the rate of inflation remains under relative control, most developed economies regard a low rate of inflation as one sign of a healthy economy. Central banks, like the US Federal Reserve, carefully monitor the rate of inflation and use the tools at their disposal--like control of short-term interest rates and the rate at which new funds enter the monetary supply--to keep the rate of inflation in an acceptable range.
In investment circles, inflation is often referred to as “the silent thief.” Over time, unless you structure your investments to counter it, inflation will reduce the value of your savings so that, when you need to spend them, the dollars you have will purchase less than when you originally acquired them. For example, a dollar in 1980 would have about 34 cents in purchasing power today. So, just to maintain the same purchasing power, the dollar you invested in 1980 would have needed to approximately triple in value, from then until now.
Investment in stocks is a classic hedge against inflation. Because the value of well-run companies depends on their continued ability to innovate, produce, and remain profitable, the price of their stock tends to increase faster than the rate of inflation. Let’s say that you purchased one share of Apple Computer stock on December 12, 1980; you would have spent $29. Today, that single share of stock would be worth over $7,000, after allowing for stock splits and dividends received. This illustrates why buying and holding a well-diversified portfolio of stocks has proven, over time, to be one of the best ways to help your investments grow faster than inflation and to protect the purchasing power of your assets.