One of the key factors that you must consider when you evaluate your net worth is inflation. If you are happy with the size of your retirement portfolio right now but won't be drawing income from it for another 20 years, then you must realize that you will not have the same amount of purchasing power with that money that you have today. It is therefore critical that at least some of your assets grow at a rate at least equal to the rate of inflation over time so that you can maintain your purchasing power.
Historical Rate of Inflation
The average rate of inflation over the past several decades has been somewhere around 3% per year. However, there have been periods of time where the rate of inflation was considerably higher, and other times when it was below this level (such as during the past five years, when it was 2.36%). But if you use this number as an average over long periods of time, you can see how much of an impact it will have on the real value of your net worth and your purchasing power. Using the Rule of 72, we can see that the price of goods and services will double every 24 years at this rate (72/3% = 24 years). This means that your retirement portfolio will also have to double over that time in order to keep pace with inflation.
It is also important to recognize that the rate of inflation differs for different goods and services. The Consumer Price Index that inflation numbers are based upon assigns different weightings to different areas of spending. For example, food and beverages make up nearly 15% of the index while medical costs comprise only 6.6%. Of course, since the spending patterns of the general public will not likely match the sector allocation of the index, the overall average inflation rate will affect each person somewhat differently. College tuition has increased in price at a much faster clip than the overall rate of inflation for the past several years. In fact, while the average cost of goods and services has increased by about 115% since 1986, the rate of inflation for higher educational expenses has risen by nearly 500%.
Keeping Pace with Inflation
There are several things that you can to do to protect yourself from inflationary risk. Two classes of assets that have historically outpaced inflation over time on a consistent basis, and they comprise the two basic forms of equity ownership. One is common stock and the other is real estate. Other assets can outpace inflation for short periods of time (gold and oil are two recent notable examples of this), but they lag the inflation rate over the long haul. The price of gold has spiked over $1,000 an ounce in the past few years, but it traded at around $265 an ounce for several years prior. Allocating at least a portion of your assets into a properly diversified stock portfolio can provide your liquid assets with an effective hedge against inflation over the long run. And while residential real estate values have been either flat or negative since about 2008, they have also risen faster than inflation over time (factor in the tremendous rise in home prices that preceded the crash).
When it comes to saving for college, one of the most effective strategies for combating inflation is to purchase prepaid tuition plans that lock in today's tuition price for a time in the future. Of course, this also essentially commits the student to going to the school where you bought the plan, but if this issue is already set then this may be your best option.
The Bottom Line
It is vitally important to understand how inflation can erode your net worth and purchasing power over time. For more information on inflation and how to combat it, consult your financial advisor.
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