Inflation and taxes can wreak havoc on the best-laid financial plans unless you arm yourself with the knowledge and tactics to prevent the most damage.
Today we’ll focus on inflation, which is one powerful enemy. Why? You can’t see it, there are are no laws protecting you from it and it’s not selective. Every single dollar is subject to its eroding influence.
What is inflation? – Get to know your enemy.
Inflation refers to the increase in the Consumer Price Index (CPI), which tracks the prices of goods and services that most of us buy. Inflation has averaged 3% a year from 1926 to 2009.
When prices rise, each of your dollars buys fewer goods and services – eroding your purchasing power. Just think about the price increases on everyday items such as milk, bread and eggs over the last few years. Or, consider the rise in your medical insurance premium or the tuition for your children’s education.
It’s not hard to see that if your income doesn’t rise with the rate of inflation, your lifestyle can be dramatically affected. Not all goods and services rise at the same rate, however. If you buy more items that are rapidly costing more money (education, medical costs) you’ll be more adversely affected.
How can you fight inflation?
There are a few ways to fight inflation and fortunately you don’t have to take on this fight all-alone. One of the Federal Reserve’s (the Fed) key duties is to keep inflation under control or in Fed speak: to maintain stable prices. They do this by manipulating monetary policy – usually by raising short-term interest rates but they have other tools as well.
But since inflation is a persistent foe, all the Fed can do is control the rate of inflation, not stop it altogether (which could lead to deflation, but that’s a whole other story).
Five Inflation Beating Tactics
Fortunately, there are some actions you can take with your money to hold off or minimize the erosion of your purchasing power:
1. Invest your cash reserves wisely. Financial institutions are more than happy to take your cash and pay you a low interest rate. Then it’s invested for a higher return elsewhere! Keep up with current savings and money market rates and move your money to where you can get a competitive rate on your cash. Note: money market fund rates tend to move up quickly when interest rates rise.
2. Get the raise that you deserve. When it comes time for your performance review, let your boss know what a good employee you’ve been and ask for a raise when appropriate. A stagnant salary combined with rising prices is a formula for a less abundant lifestyle or the accumulation of debt.
3.If you’re self-employed, price your product or service competitively and take price increases when you can.
4. Monitor your investments based on your time horizon (when you will need the money) and risk tolerance (can you sleep at night?). Being overly fearful of the stock market and holding too much cash will not bring you abundance in your golden years.
5. Certain assets rise with inflation. Treasury Inflation-Protected Securities, gold, commodities, and real estate are examples of assets that typically rise with inflation. If you own a home, this is probably enough real estate. One of the easiest ways to invest in commodities and gold is through exchange-traded funds. Careful though, these assets can be volatile and you would only want a small percentage of a balanced portfolio invested in them. Educate yourself or get help before dipping your toe in!
Here are a few resources to get you started on inflation fighting.
From the Get Rich Slowly Blog: Best High-Yield Savings Accounts
From Morningstar: Exchange Traded Funds
From the SEC website: Asset Allocation, Diversification and Rebalancing
Next Up: Money’s Enemy #2: Taxes (To be posted soon).