Inflation may diminish future purchasing power

Recent spikes are causing concern, and experts don’t predict any short-term drops. The reality is that rising energy costs could work their way into the costs of goods and services that consumers need, leading to rising inflation.

The inflation factor

Even if inflation doesn’t soar out of control, it’s dangerous to underestimate its power in planning long-term financial goals. Let’s say, for example, that inflation averages 3 percent over the next 30 years. If you’ve saved $100,000 during those three decades, it would be worth only $40,000 at the end of that time.

Here’s another example that brings to reality how inflation can diminish purchasing power: With an average annual inflation rate of 4 percent, the car you buy today for $23,000 would cost $50,396 just 20 years from now. Higher rates of inflation could be even more harmful to your future financial security.

To protect your portfolio from the corrosive effects of inflation, consider these ideas.

• Invest to beat inflation. You might think that investing in stocks is a bad idea the way the stock market dropped when the Fed recently went public with inflation concerns. While these short-term blips may prove alarming for investors with goals that are just around the corner, long-term investors should take a different perspective.

In the long run – 10, 20, 30 years or more – stocks may provide the best potential for returns that exceed inflation. While past performance is no guarantee of future results, stocks have historically provided higher returns over time than other asset classes.

Consider these findings from Standard & Poor’s: Between 1926 and 2005, the annual return for a portfolio comprised exclusively of stocks in S&P’s 500 Index was 10.42 percent – well above the average inflation rate of 3.25 percent for the same period. The average annual return for long-term government bonds, on the other hand, was only 4.89 percent.

While historical data creates a compelling case for stock ownership, some investors are squeamish about individual stock selection. If you’re among them, stock mutual funds may be more in your comfort zone. Stock funds offer the same growth potential as individual stocks, plus the benefit of professional management.

• Maintain a diversified mix. While stocks offer the best inflation hedge over the course of time, they do involve greater fluctuation risk than many other investments. That’s why it’s best to construct a portfolio with the blend of investments with which you are comfortable. The key to diversifying your portfolio is to consider your time frame, your tolerance for risk and your anticipated income needs down the road.

If you are young and have 30 or 40 years until retirement, a mix of 70 percent stocks and 30 percent bonds may be appropriate. As retirement approaches, you may want to reduce your stock holdings while still maintaining some growth-oriented investments as a hedge against inflation. After all, your retirement assets may need to last 30 years or more and inflation will continue to work against you during that time.

• Look at the big picture. Like death and taxes, inflation is inevitable. You can, however, control how you deal with the inevitable. A knowledgeable financial adviser can help you see the big picture and assemble a diversified portfolio that’s right for your goals and your time frame – keeping important factors like inflation in mind.

Paula Dougherty, CFP, ChFC, CLU is a Certified Financial Planner with Ameriprise Financial. She may be reached at paula.j.dougherty@ampf.com.