Just a few years ago, economists were talking about the possible re-emergence of an economic phenomenon not seen in many decades: deflation, or declining prices of goods and services.
Recently, however, inflation has risen from extremely low levels, driven largely by increased energy and grocery prices. As a consumer, you might fight the effects of inflation by driving less or by cutting back on certain types of food. But as an investor, what can you do to help keep your financial assets from losing purchasing power?
Your first step is to be aware of how inflation affects different types of investments. For example, if you've tried to be a "risk-averse" investor, you might have built a portfolio that's heavy with bonds and certificates of deposit - yet these same types of fixed-rate investments are actully the ones that are most susceptible to inflation.
On the other hand, stocks, over the long term, have significantly outpaced inflation. In fact, over the past 80 years, stocks have shown an average return of more than 10 percent, compared to an average inflation rate of about 3 percent, according to Ibbotson Associates, a financial services research firm.
Of course, as you've no doubt heard, "past performance is no guarantee of future results." In any given year, the inflation rate could be higher than the stock market's return, and, in fact, you could lose some or your entire principal by investing in stocks.
Nonetheless, if you want your overall portfolio to stay ahead of inflation, you almost certainly will need some exposure to the growth potential found in stocks. You may be able to lower your risk level by buying quality stocks, holding them for the long term and including them in a portfolio that also contains bonds, U.S. Treasury securities and other investments.
In creating an investment strategy to fight inflation, you'll also need to factor in your stage of life. During your working years, you probably count on your salary, more than your investment portfolio, to help meet your living expenses. So as long as your wages keep pace with inflation, you may be able to focus your investment efforts on accumulating the assets you'll need to enjoy a comfortable retirement lifestyle. But when you actually reach retirement, you'll almost certainly need to draw on your portfolio as a major source of income - which means you'll need to pay a lot of attention to inflation.
Consider this: If inflation rises 3 percent a year, then everything you buy today could cost twice as much in 24 years. And since you could easily spend two or three decades in retirement, you can see just how much inflation could threaten your standard of living.
Consequently, during your retirement years, you'll need to invest for rising income. You may be able to get some of this income through dividend-paying stocks; some of these companies have actually increased their dividend every year for 20 or 25 years. (Keep in mind, though, that dividends can be increased, decreased or eliminated at any time without notice.) You also may want to consider certain types of inflation-adjusted treasury bonds.
You can't control inflation. But you can help tame its effects - by investing for growth and rising income.