Impact of Inflation on Investments

When investing for long-term goals, it is important to consider the effects of inflation on your investment returns. Over time, inflation can erode the value of an investment; even today's moderate inflation rate can have a large impact on the purchasing power of your money over 20 or 30 years.

Fiat Money vs. Inflation

The value of fiat money is essentially determined by public trust in the issuer. Commodity money's value, on the other hand, is determined by the material used to make it, such as gold or silver. As a result, fiat money has no intrinsic value, while commodity money often does. Changes in public confidence in a government issuing fiat money can be sufficient to render it worthless.

Commodity money, however, retains value based on the metal or other material content it has. Fiat money is therefore more at risk of inflation because its value is not intrinsic.

Since fiat money is not tied to physical reserves such as a national stockpile of gold or silver, it is vulnerable to inflation and, in the case of hyperinflation, to becoming unsustainable. When people lose confidence in a country's currency, the monetary system loses its worth. This differs from gold, for instance since it has intrinsic value.

The most important inflationary feature of fiat currency is that it allows the central banks to print or hold money as they see fit to help control the money supply, inflation, interest rates, and liquidity. Moreover, Fiat money contains inflation by controlling the interest rates and by creating more or less money in the system. But that creation of more money can lead to devaluing of that money over time.

Importance of Investing to Beat Inflation

It's important to understand the impact of inflation on your investment returns while planning for the long term. Inflation can erode the worth of an investment over time; even today's modest inflation rate can have a huge effect on your money's buying power in 20 or 30 years.

If you want to accomplish long-term financial goals, such as college savings for your children or your own retirement, you'll need to develop an investment portfolio that will generate adequate returns after inflation is taken into account. Long-term, diversifying your portfolio of stocks and mutual funds can give you the best chance of outperforming inflation.

Build a Strategy

If you plan to achieve long-term financial goals, from college savings for your children to your own retirement -- you'll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation. Diversifying your portfolio with stocks and stock mutual funds may offer the best chance of beating inflation over the long term. While past performance is no guarantee of future results, stocks have historically provided higher returns than other asset classes.

How Inflation Erodes Monetary Value

It's easy to ignore inflation while planning for the financial future in today's economy. A 4% inflation rate will not sound significant when you realise the long-term effect it may have on your purchasing power. For example, 4% annual inflation will significantly lower the value of a dollar to $0.44 in just 20 years.