When you’re investing for your future, the one thing that many ( dare I say most? ) people forget to consider is the effects of inflation. Inflation has an incredibly powerful effect on the value of your money, and if you ignore it, your standard of living will be much, much lower than you expect.

What is inflation?

Basically, inflation describes how the cost of goods and services rise every year. Traditionally in the United States, inflation averages about 3-4% per year. That’s a very rough average, and can vary drastically. It is a good benchmark for the long term however. Just like stock returns can vary, inflation does the same. If inflation is 4%, that means that things cost about 4% more than they did a year ago. So effectively, any money you have sitting around is worth 4% less. And that happens each and every year, just like winter and taxes.

Do the math - you might be surprised

If you’re keeping your money under your mattress, or behind your toilet tank, then inflation is slowly stealing your life savings. If you have $10,000 under your mattress today, in ten years it will be worth just $6648.33 in today’s dollars, if we assume 4% inflation. Inflation took over $3300 from you - that’s not a good use of your money! If you had kept that same $10,000 in an online savings account that paid 4%, then you would end up with $10,000 in today’s dollars, 10 years from now. That’s before taxes, of course, but you see the difference. By using the mattress account, you cost yourself over $3,300.

Beat Inflation

To beat inflation, and keep the value of your money growing, you must invest smartly. If inflation is 4%, you must earn a higher rate of return than 4% so that your investment value goes up. Stay with me, if that didn’t make sense. An investment into an index fund ( one of my choices for smart, “safe” investments ), should net you roughly 10% per year. The “after inflation” value of your investment will grow by 6% per year - 10% minus 4% inflation. This would be a good investment. If you can manage a12% per year return, then you’ll be looking at 12% - 4% inflation, for a “real” return of 8%. That’s 25% better than if you had earned 10% per year - even though 12% is only 20% higher than 10%. That’s a whole lot of percentages, so please read this paragraph twice if things don’t quite line up for you. Check out the following table for a quick overview as well:

Investment Return Inflation “Cost” “Real” Return
10% 4% 6%
12% 4% 8%
15% 4% 11%
20% 4% 16%

Individual stocks are the key

As you can see, as the rate of return grows, the “real” or after-inflation, return grows even more quickly. To achieve these higher returns, movement away from “safe” or low-risk investments will be needed. You must invest in individual stocks to truly maximize your returns. If you want to truly beat inflation, then there is no better way than by picking strong, undervalued stocks that have a lot of movement for growth. Nerves of steel are an absolute must, because stocks can and do fluctuate - sometimes wildly. But they are the one and only way to truly beat inflation.

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