Key takeaways
- Inflation describes a rise in the level of prices for goods and services. As inflation rises, the same amount of cash buys fewer goods and services, reducing purchasing power.
- Cash and money market deposits typically earn low returns and so when inflation exceeds their returns, as it has done frequently historically, they will lose purchasing power over time.
- To consistently counter the effects of inflation, investments need to grow at a faster rate than prices rise. Diversified portfolios can be effective in achieving this while managing risk over the long term.
What is inflation?
Inflation is the term used to describe the rate at which the general level of prices for goods and services rises. A rise in prices leads to a decrease in the purchasing power of cash as the same amount of cash buys fewer goods and services when the prices of these rise.
Inflation has existed since the inception of modern economies, though its rate fluctuates over time. Inflation is often measured using the Consumer Price Index (CPI) which tracks the changes in price for a basket of goods and services bought by households. It thus provides an indicator of the cost of living and the purchasing power of cash.
Effect on purchasing power
The loss in purchasing power refers to the gradual decline in what money can buy over time due to inflation. If inflation is higher than the return on cash, then the after-inflation, or “real” value of that cash decreases - meaning individuals can purchase less with the same amount of cash.
To illustrate this point, the chart below shows the hypothetical impact of different levels of inflation on $100 over time. After a period of 30 years, an average inflation rate of 3% would have translated in a loss of $60 dollars of purchasing power, or equivalently $100 would have the same purchasing power as $40 at the start of the period.
Cash and money market deposits
Cash and money market deposits often earn low-interest rates, and so when inflation outpaces these interest earnings, they lose value in after-inflation terms. This will reduce the purchasing power of any funds held in these forms, eroding wealth when the returns do not outpace inflation.
Countering the effects of inflation
To maintain and grow the purchasing power over time, investments need to grow at a rate above inflation. Possibilities for this include both investments that are linked to the rate of inflation, and those that grow on average at a faster rate than inflation.
The returns on some assets are directly linked to a rate of inflation, for example inflation-linked bonds, for example US Treasury Inflation Protected Securities (TIPS). Such assets may help to maintain the purchasing power of invested funds over time. Others may be indirectly linked to inflation through their ability to pass on any rise in prices through increasing their own charges, such as rents. Examples include selected real estate and infrastructure assets.
Other investments that can help to preserve and grow purchasing power over time, include those that tend to increase in value faster than the rate of inflation.
These include certain bonds and fixed income assets, as well as equities and alternative assets that have historically offered higher returns than inflation on average but also involve taking more risk than a cash or money market investment.
Diversifying investments across a mix of asset classes can also be a good way of countering the effects of inflation over time while managing portfolio risk.