“That’s it, I’m getting out of the market.”
Sound familiar? Many of us have this thought when we see stock prices go up and down wildly in a short period of time. It’s only natural to worry about the impact of market volatility on your investments. To avoid the risk, you might even be tempted to put all your savings into cash, short-term investments, or other seemingly “safe” options.
So why shouldn’t you? Because there’s another financial risk to consider: inflation.
What is inflation?
Simply put, inflation is the increase in the prices of goods and services over time, which eats away at your money’s purchasing power. When you invest or save, you want to earn as much as you can on your money, over and above inflation (as long as you understand and are comfortable with the risks), so you can purchase the most with that money.
For example, let’s say have your eye on a $30,000 car but want to wait until next year to buy it. Here’s how inflation might eat into your plans if you don’t invest your money carefully:
| What you’ll save if you put your $30,000 in a savings account that pays 2% interest a year | What your car will cost in a year, if inflation is at 3% | How much more money you’ll need at the end of the year to buy your car |
|---|---|---|
| $30,000 x 1.02 = $30,600 | $30,000 x 1.03 = $30,900 | $30,900 - $30,600 = $300 |
Right now, inflation is high. But many people expect inflation to rise before long, thanks to a growing economy. In other words, it’s something you should always consider.
Why the "safest" investment isn’t necessarily safe
When many of us talk about the risk of investing, we’re talking about investment risk, or the risk that a given investment will go down in value. That’s why we tend to want to flee the market when stock values are volatile. However, inflation risk is another risk to consider at the same time. Inflation risk is the possibility that inflation will reduce the value of your investments because they can buy less over time.
The amount you earn on your investments after subtracting inflation is sometimes called your “real return” because it takes into account the purchasing power of your money after inflation. Consider this: if you put all your money in an investment that pays zero interest when inflation is averaging 3% a year, the real value of your investment would actually decrease by 3% a year—in other words, your “real return” would be negative 3%. Similarly, if inflation is 3% and your investment pays 2%, your real return would be negative 1% because you’d lose 1% a year in purchasing power. Understanding inflation and your real return will help you understand what your money will buy when you’re ready to spend it.
Protecting your portfolio from inflation
How can you help protect yourself from inflation risk? The same way you can help protect yourself from investment risk—by following an appropriate asset allocation strategy and diversifying your savings. More specifically, if you want to minimize the effects of inflation on your long-term savings, you may have to accept some investment risk and choose a portfolio of investments that, on average, will give you returns that exceed the rate of inflation. It’s really a balancing act—through diversification and asset allocation, you can balance investment risk with inflation risk by choosing a mix of short-term investments, equities, and bonds to meet your needs. Diversification and asset allocation do not ensure a profit or guarantee against loss.
Asset allocation means diversifying your investments across each of these three categories:
- Short-term investments – Also referred to as money market or cash investments, short-term investments tend to have the least investment risk of the three basic investment types. But they also tend to produce the lowest returns over the long run, subjecting them to inflation risk.
- Equities – Equities—commonly referred to as stocks—give you a greater potential for investment growth. But they also come with a higher investment risk.
- Bonds – Also known as fixed-income investments, bonds can help offset some of the investment risk equities can create—but they may carry their own risks. In general, bond prices rise when interest rates fall, and vice versa. In addition, because bonds provide a fixed income stream, inflation can eat away at that value. However, one type of bond investment—U.S. Treasury Inflation-Protected Bonds (TIPs) and funds that invest in them—has principal that is adjusted for increases in the inflation rate. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
The bottom line: investment risk isn’t the only kind of risk when you invest. If you “play it safe” and choose only cash equivalents or bonds, inflation can eat away at your potential returns. A balanced asset allocation appropriate for your age and risk tolerance may be the best strategy.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Investing in bonds involves risk, including interest rate risk, inflation risk, credit and default risk, call risk, and liquidity risk.
You could lose money by investing in a money market fund. An investment in a money market fund is not a bank account and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Before investing, always read a money market fund’s prospectus for policies specific to that fund.
Investing involves risk, including risk of loss.
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Balance risk, not just returns
Market volatility isn’t the only risk investors face. A diversified portfolio can help balance investment and inflation risks over time.
