Updated: Nov 9
Investors have come to expect inflation will accelerate as the federal government continues to use massive stimulus plans to fuel the economic recovery. The question is how high will inflation go and will your investments keep up with those increases.
This has been a concern for many ever since the Federal Reserve began quantitative easing back in 2008. It’s hard to know what levels we will see, especially following stimulus spending over the past year, but it’s certainly a risk more on the radar for investors.
And it should be. Inflation erodes your purchasing power. In a year of 4 percent inflation, $1,000 in your mattress only buys $960 in goods and services.
Inflation is always something investors need to be concerned about because the whole point of investing money is to keep up with or outpace the rising standard of living. Investing in the stock market is a hedge against inflation for a few reasons.
According to Ramsey Solutions, since 1926, the U.S. stock market average return is more than 10% per year while inflation has averaged roughly 3% per year. That means all told stocks have grown at nearly 7% more than the rate of inflation.
One of the reasons for this is that earnings and dividends grow faster than inflation. Over the past century, earnings have grown at roughly 5 percent per year. And dividends have also grown at roughly 5 percent per year. Together they both yield 2 percent more than the average inflation rate and while that is not a monstrous return, it’s still positive. So earnings and dividends both have a history of growing above the rate of inflation.
During periods of higher inflation, the overall returns in the stock market are lower than average but certain areas of the market tend to do better in those times. Value stocks tend to perform better than growth stocks when inflation rises.
Some people invest in precious metals like gold as a hedge against inflation but the drawbacks often outweigh the benefits. It can be tricky business to grow the value of your portfolio with precious metals.
Gold may not be the hedge you think it is. It hasn’t been possible to convert the U.S. dollar into gold since President Richard Nixon ended that practice in 1971. If dollars were still backed by gold, then it could provide that hedge if, but that is simply not the case. In the long run, stocks are still the best bet for protecting your portfolio against inflation. We do not know how much inflation we might see over the next year but for most investors, stocks can help protect your investments against the eroding power of inflation.