Without really knowing it, most people invest their savings in investment vehicles, such as mutual funds, because they want to beat inflation. If you save your money by burying it in jars in your back yard or by stuffing it under your bed mattress, you will lose to inflation because the cost of living grows while the value of your money does not (even though you may have "planted" it in the ground)! In fact, you may still lose to inflation even if you save your money in a bank account or Certificate of Deposit (CD).
For example, the average historical rate of inflation is roughly 3.40%. Let's say you are feeling financially responsible and put your hard-earned cash into a CD, earning 2.00%, at the local bank. Doing some quick math, you can calculate the difference (3.40 - 2.00 = 1.40) and see that you are still losing to inflation by 1.40%. This doesn't even factor in the effect of taxes on your savings, which would reduce your real rate of interest (after inflation and taxes) to roughly 0.10%, assuming a top federal tax rate of 25%. Therefore, in a low interest rate environment, you could save money in a CD but still value because of inflation and taxes -- you are doing what I call "losing money safely."
The best way for most people to beat inflation--to achieve returns averaging more than 3.40% -- is to invest in some combination of stock and bond mutual funds.
Building a portfolio of mutual funds is similar to building a house: There are many different kinds of strategies, designs, tools and building materials; but each structure shares some basic features.
To build the best portfolio of mutual funds you must go beyond the sage advice, "Don’t put all your eggs in one basket:" A structure that can stand the test of time requires a smart design, a strong foundation and a simple combination of mutual funds that work well for your needs.
Diversification with mutual funds is more than just putting your eggs into different baskets. Many investors make the mistake of thinking that spreading money among several mutual funds means they have an adequately diversified portfolio. However, different does not mean diverse. Be sure you have exposure to the different categories of mutual funds.
As the name implies, growth stock mutual funds typically perform best in the mature stages, such as inflationary periods, of a market cycle when the economy is growing at a healthy rate. The growth strategy reflects what corporations, consumers and investors are all doing simultaneously in healthy economies--gaining increasingly higher expectations of future growth and spending more money to do it.
When inflation intensifies, the value of the US dollar may fall. Therefore foreign stock funds can act as an automatic hedge as money invested in foreign currencies is translated into more dollars at home.
Bond funds can lose value in inflationary environments because bond prices move in opposite direction as interest rates, which rise along with inflation. However, a wise investor will still diversify with bond funds and will therefore find the best bond funds for rising interest rates:
- Short-term Bonds: Rising interest rates make prices of bonds go down but the longer the maturity, the farther prices will fall. Therefore, shorter maturities will do better in a rising interest rate environment.
- Intermediate-term Bonds: Although the maturities are longer with these funds, no investor really knows what interest rates and inflation will do. For example, even the best fund managers thought inflation would return in 2011, which would bring on higher interest rates and make short-term bonds more attractive. They were wrong and fund managers lost to index funds.
- Inflation Protected Bonds: Also known as Treasury Inflation-Protected Securities (TIPS), these bond funds can do well just before and during inflationary environments, which often coincide with rising interest rates and growing economies.
When interest rates are rising, investors wanting the relative safety of CD's may consider a ladder approach, which means new CD's with short redemption periods, such as one year or less, and are purchased periodically, such as once per month or once every few months, to capture the higher rates as they rise. The idea is to climb the figurative ladder progressively higher. After several months, your newest CD will likely receive the highest rate. Once interest rates appear to be stabilizing, you may consider locking in the higher rates for longer holding periods.
Inflation indicates a growing economy, which is usually a good environment for sectors, such as energy, technology and financial stocks, that tend to do well in growth periods.
Tip and Caution
Trying to navigate market and economic conditions with investment strategies is a form of market timing that carries significant risk of losing value in an investment account. For most investors, building a diversified portfolio of mutual funds is the best strategy for all market and economic environments.
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.