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For an investor, inflation can prove to be a formidable adversary. Inflation can greatly limit your gains so it is important to understand it because it will help you decide which investments to make as well as your investment strategy.
Over time, people realized that they could collect gold and issue currency in its place. The currency acted like gold but was even more convenient to use and was more portable.
Well, running a country is a very expensive task, especially during wartime. As countries began running low on their gold supply, they realized that they could print an unlimited supply of currency, thus creating instant wealth. Sounds great, doesn't it? Not really because as all these new bills and coins were minted and circulated, there was no gold backing them up. This meant that prices would go up and the buying power of a form of currency decreased and this is what is known as inflation.
Producing more money is helpful when the supply of gold runs out but it can prove disastrous. During the late 1910's and early 1920's, Germany was producing so many marks (the form of currency there) that inflation was running rampant. In fact, women often burnt marks notes because it was cheaper to burn them than use them to buy fire wood!
The United States never had an inflation problem this bad but during the 1970's, Vietnam was costing the nation a great deal of money so the Treasury printed more dollars which inflated the economy. Because of this, inflation hit double digits for a couple of years.
Inflation also hurts us as investors. When you check up on your portfolio at the end of the year and you see you made 20%, you're ecstatic but you have to remember inflation. If inflation was at 3.1% (the historical average), you would really only have 16.9%, which is still excellent. However, if you invested in bonds and made 5.5%, inflation would have eaten away and caused your gain to be much less- 2.4%. If all your money is in cash, you will actually be losing 3.1% of your buying power each year.
One way to measure inflation is to keep an eye on the consumer price index (CPI), which measures the cost of living. If the costs of living are rising, it generally means that inflation is also rising.
When investing, it is always important to know what the inflation rate is. If it is a high number, you wouldn't want to invest in a low-yielding bond. Stocks and mutual funds are usually a better investment if you would like to have a higher return than the current inflation rate. However, as long as your money isn't stashed underneath your bed sheets, you will be at least be making an attempt to keep inflation at bay.
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The Consumer Price Index
Before learning what inflation is, you should have an idea of how money works. Many years ago, gold became the standard for buying and selling items. It was usually preferred because it could be formed into coins and transported easily. After all, would you rather carry a few coins or bring your cow (to trade in) to the market?
Inflation Calculator
Enter an amount and a year and find out how much that same amount would be worth today.
Frequently asked questions and answers about the Consumer Price Index.