Inflation-Proof Your Portfolio

If you need proof that inflation is real, look no further than a local car dealership. The average price of a new car is now more than $28,400.¹ In 1971, this would have been enough to buy the average new house, which sold for $28,300.²

Inflation is the overall increase in the prices of goods and services over time. Some inflation can be good for the economy, but the downside is that inflation slowly weakens the purchasing power of a dollar.

Is it possible to inflation-proof your portfolio? Maybe — it depends on your risk tolerance.

Dangerous Duo

Inflation and taxes are two major dangers facing your portfolio. As you can see from the accompanying equation, after subtracting inflation and taxes from a hypothetical 6 percent rate of return, the real rate of return might be just 1 percent.

This would seem to indicate that a higher rate of return is the obvious answer to inflation. But remember that investments seeking to achieve higher returns also involve a higher degree of risk. An investor seeking a significantly higher return would probably need to invest more heavily in stocks. For a worker who is still decades from retiring, taking on more risk might be appropriate. Someone who is much closer to retirement or already retired may be far more cautious about risk because there isn't much time to recover from large losses.

Inflation is a deadly foe. Any effort to offset the effect of inflation on your portfolio should be based on a thorough review of your personal circumstances.

1) National Automobile Dealers Association, 2006
2) Haver Analytics, 2006