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Investing Basics

Resources: Investing Basics: Inflation

Inflation happens when the prices of goods and services increase and purchasing power decreases — in other words, you are able to buy fewer goods and services for the money you spend. Inflation also occurs as a natural part of the business cycle and accompanies economic growth. It has the effect of deteriorating the value of an asset or income stream.

What is inflation?

Inflation occurs when prices rise as spending increases relative to the supply of goods or services available in the marketplace. Some economists have described inflation as too much money chasing too few goods. In an inflationary environment, cash is worth slightly less each year than it was the year before. For example, if inflation is 4% per year, the price of goods rises by an average of 4% each year. So each year, your dollar buys 4% less than it did the year before.

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When your dollar holds still

If you do not invest your money at all, and there is a small amount of inflation, you lose buying power over time.

Investing your cash in cash equivalents, such as Treasury bills (T-bills) and money market instruments, may help keep your principal more stable and give you the potential for small returns. Because of this, they are good short-term savings vehicles. But in the long run, they will probably not give you high enough returns to outpace inflation.

Being conservative and not investing has its drawbacks. Not taking enough risk when you invest is the biggest risk of all. Invest too conservatively, or not at all, and you run the risk of not matching inflation. This can derail your financial plan. It could mean running out of money when you retire.

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How to outpace inflation

If you hope to keep the same standard of living you have now over the long-term, your investments will need to give you a rate of return equal to or better than the rate of inflation. What investments can help you do that?

Historically, stocks have offered the best opportunity for long-term growth. But stocks and equity mutual funds expose you to high risk of short-term price changes. That's one good reason to both diversify your investments and invest for the long term.

A disciplined, steady approach can help you stay on track to meet long-term goals. To learn more, read the article Dollar Cost Averaging.

The article Asset Allocation will teach you how to help minimize risk and maximize your potential for returns by spreading your investments across different asset classes.

To learn the basics about stocks, bonds, mutual funds and more, read Types of Investments.

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