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Anyone who has paid for gasoline, health care or college
tuition lately knows that even if the overall rate of inflation
is modest, there are areas where costs are rising more dramatically.
Earning returns that exceed the cost of living is important
for all investors, but it is especially critical for those
who may depend on their portfolios as a source of income.
What Is Inflation?
Inflation is the increase in the price of any good or service.
The most commonly referenced measure of that increase is
the Consumer Price Index (CPI), which is based on a monthly
survey by the U.S. Bureau of Labor Statistics. The CPI compares
current and past prices of a sample "market basket" of
goods from a variety of categories including housing, food
and transportation.
Inflation has been a consistent fact of life for U.S. consumers.
Between 1900 and 1970, inflation was moderate, averaging
2.5% annually. From 1970 to 1990, however, the average rate
increased to around 6%, hitting a high of 13.3% in 1979.1
Recently, rates have been closer to the 2% to 4% range, averaging
3.2% in 2006.
What It Means to Your Finances
An inflation rate of 4% might not seem significant until
you consider the long-term effect on your purchases and your
investments. For example, in 20 years, 4% inflation annually
would drive the value of a dollar down to $0.44.
The Cost of the Future2
| Item |
Price in 2006 |
Price in 2026 |
| Stamp |
$0.39 |
$0.85 |
| Refrigerator |
$1,000 |
$2,191 |
| Automobile |
$23,000 |
$50,396 |
Inflation also works against your investments. When pursuing
long-term financial goals, from college savings for your
loved ones to your own retirement, it's important to consider
the real rate of return, which is determined by figuring
in the effects of inflation.
Investing to Beat Inflation
Over the long run - 10 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 than other asset
classes. A Standard & Poor's analysis of holding periods
between 1926 and 2006 found that the annual return for a
portfolio comprised exclusively of stocks in the S&P
500 was 10.49% - well above the average inflation rate of
3.04% for the same period.3 The average annual return for
long-term government bonds, on the other hand, was only 4.86%.
A Balancing Act
Keep in mind that stocks do involve greater risk of short-term
fluctuations than other types of investments. Unlike a bond,
which guarantees a fixed return if you hold it until maturity,
a stock can rise or fall in value based on daily events in
the stock market, trends in the economy or problems at the
issuing company. But if you have a long investment time frame,
you may find that stocks offer the best chance to beat inflation.
The key is to consider your time frame, your income needs
and how much volatility you are willing to accept, and then
construct a portfolio with a mix of stocks and other investments.
For instance, if you have 30 or 40 years until you plan to
retire, a portfolio weighted to stocks or stock funds might
be suitable. But even if you are approaching retirement,
you may still need to maintain some growth-oriented investments
as a hedge against inflation. Your retirement assets may
need to last for 30 years or more, and inflation will continue
to work against you throughout.
There are many ways to include stocks in your long-term plan
in whatever proportion you decide is appropriate. You and
your financial advisor could create a diversified portfolio
of shares from companies you select. Another option is a
stock mutual fund, which offers the benefit of professional
management. Stock mutual funds have demonstrated the same
long-term growth potential as individual stocks. S&P
tracked domestic equity mutual funds from 1987 through 2006
and found an average annual return of 11.8%.4
Whether you're a first-time investor or an experienced retiree,
you need to keep inflation in your sights. Stocks may be
your best weapon, and there are many ways to include them.
Your financial advisor can help you determine your best options.
1Source: U.S. Bureau of Labor Statistics.
2Based on an average annual inflation rate of 4%.
3Source: Standard & Poor's. Performance is for the period
December 31, 1926, to December 31, 2006. Stocks are represented
by the total return of the S&P 500 Index, bonds by long-term
Treasuries (10+ years). Past performance cannot guarantee
future results. Individuals cannot invest directly in any
index. Results include reinvested dividends.
4Source: Standard & Poor's. Based on average annual returns
of all U.S. equity funds, including sector and balanced funds.
Does not reflect sales charges or other expenses associated
with purchasing mutual fund shares. Past performance is no
guarantee of future results.
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