While most risks associated with investing are easy to understand, inflation can be challenging to comprehend. This may stem from the fact that the damages from inflation can take years to appear... sort of like rust on the undercarriage of a car. You can't easily see it, but over the years it takes its toll.
Inflation is defined as the general increase in prices in relation to the drop in purchasing power of money. In order to maintain price stability, the Federal Reserve has targeted inflation at 2% annually. For years, the rate of inflation has been relatively low, but that hasn't always been the case.
Perhaps the best way to understand the effects of inflation is a conversation around the table at a family holiday meal (remember when we used to have those):
Granddaughter: PopPop, what was your first car?
Granddad: A 1965 Ford Mustang. We paid $3,000.00 for it, brand new... wish I still had that car.
Granddaughter: How about you, Mom?
Mom: 1990 Honda. The down-payment was $3,000.00.
Granddaughter: ...guess I'll need $3,000.00 just for an oil change!
(Meanwhile, the house they're enjoying the holiday meal in has a school tax bill higher than it originally cost to build.)
That's inflation. Now what can investors do about it?
Historically, the asset classes that fared best against inflation are equities (stocks), real estate and certain commodities. The asset classes that are most susceptible to damage from inflation are bonds and cash.
As the economy continues to recover from the pandemic, we will likely see talk of inflation remain in the headlines. Our best defense is a well-diversified portfolio... having the appropriate mix of stocks, bonds, and cash.