Inflation is one of the most important factors that you should take into account when you are planning your finances. Without proper measures, inflation can make a huge dent on your savings. That is why it is critical to understand how inflation works and what you can do to protect your finances.
In simple terms, inflation is the increase in prices over a certain period. In a typical economy, the prices of goods and services rise with time. Although this might not true for all products, this does hold for most of the essential things. When you are planning your savings, you should consider this potential increase in price to be able to afford everything that you would need in future.
In the U.S., inflation as measured through the consumer price index. This index covers a typical basket of goods and services that an average consumer buys. The long-term average of the consumer price index is around 3%. This means that if you have to pay $100 for your regular supermarket shopping today, you will have to pay $103 for buying the same products next year. The year after that you will have to pay about $106, and 20 years later, you’ll have to pay about $180.
This might not sound much as far as supermarket shopping is concerned, but when you consider other costs like medical expenses, car prices, fuel costs, electricity etc, your spending power will be significantly diminished by the time you retire. So if retirement savings of $500,000 seem sufficient to you in today’s prices, you would actually need about $900,000 if you retire after 20 years.
The good news is that there are some steps that you can take to beat inflation. The most important thing is to never keep your savings in an investment that pays lesser interest than inflation. By investing in such an asset, you are in fact losing money!
You can allocate some part of your portfolio to high yield deposits. These pay much more than regular deposits and your investment would easily grow faster than inflation. The stock market can also give sufficient long term returns to beat inflation. But as it involves a lot of risk, you would have to choose your stocks or funds carefully so that you can earn decent returns without taking too much risk. Don’t look for very high profits as assets that promise higher returns always involve higher risk.