What is inflation, and how should it affect my investing?

Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return (%) their investments need to make for them to maintain their standard of living.

The easiest way to illustrate inflation is through an example. Suppose you can buy a burger for $2 this year and yearly inflation is 10%. Theoretically, 10% inflation means that next year the same burger will cost 10% more, or $2.20. So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy as many burgers. However, a one-time jump in the price level caused by a jump in the price of oil or the introduction of a new sales tax is not true inflation, unless it causes wages and other costs to increase into a wage-price spiral. Likewise, a rise in the price of only one product is not in itself inflation, but may just be a relative price change reflecting a decrease in supply for that product. Inflation is ultimately about money growth, and it is a reflection of "too much money chasing too few products".

There are several other variations of inflation:

• Deflation occurs when the general level of prices is falling. This is the opposite of inflation.
• Hyperinflation is extremely rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
• Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in the industrialized countries during the 1970s when a bad economy was mixed with OPEC raising oil prices.

One way to protect yourself from the effects of inflation is to invest. Achieving an investment return that beats the current rate of inflation ensures that your wealth isn't shrinking. The impact inflation has on your portfolio, however, depends on the type of securities you hold. If you invest only in stocks, you don't have to stay up at night worrying about inflation since over the long run, a company's revenue and earnings should increase at the same pace as inflation. But fixed-income investments (such as bonds) don't do so well in an inflationary environment. A popular fixed-income security used to negate the effects of inflation is U.S. Government's Treasury Inflation-Protected Securities (TIPS). TIPS are very similar to bonds, but the coupon rate is adjusted for the changing rate of inflation. Unfortunately because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-indexed securities simply don't make sense.