Inflation is an economy-wide, sustained trend of increasing prices of goods and services, and loss of dollar purchasing power from one year to the next. It affects investments in several ways:

Real Value Erosion:

The rate of inflation represents how quickly investments lose their real value and how quickly prices increase over time.

As prices rise, the purchasing power of money decreases. For example, if you can buy a burger for $2 this year and the yearly inflation rate is 10%, next year the same burger will cost $2.20.

To maintain your standard of living, your investments need to generate returns equal to or greater than inflation.

Investment Returns and Inflation:

If your investment returns do not outpace inflation, your real returns (adjusted for inflation) may be negative.

Suppose ABC stock returned 4% and inflation was 5%. The real return on investment would be minus 1% (5% – 4%).

Asset Classes and Inflation:

Liquid assets (e.g., cash, short-term deposits) tend to appreciate more slowly than other assets. They are more vulnerable to the negative impact of inflation.

Illiquid assets (e.g., real estate, long-term investments) are also affected by inflation but may appreciate in value or generate interest, providing a natural defense.

In summary, understanding inflation is crucial for making informed investment decisions. Consider investments that can keep pace with or exceed inflation to protect your purchasing power over time.