Investments to Fight Inflation

If you're not worried about inflation's effect on your future, you should be. It can really eat away at the value of your money. It has averaged around 3% annually over long periods, which is enough to turn a seemingly sizable nest egg into just a few bites of an omelet. Viewed on a shorter-term basis, a 3% inflation rate for the year is enough to turn a 10% return on your investment over a year into a "real" return of less than 7%. In case you're not convinced yet, here's one last example: What would cost you $100,000 today will cost you over $240,000 30 years from now, if inflation averages 3%.

Now that you're a little worried, permit me to worry you even more with a new consideration: our current economic crisis. One of the possible (though not necessarily certain) long-term effects of our stimulus packages could be a future hike in inflation. In an inflationary environment, if you leave a lot of money in cash, it will shrink in value year by year. It might look the same, but it will buy less, and that's what really matters. Even leaving long-term money in a bank account can be disastrous, if it's earning you 2% interest while you're dealing with 4% inflation.

So how do you beat inflation? There are several ways.

Index funds and dividends
A simple index fund has a lot to offer, which is why we've recommended them pretty much since the dawn of Fooldom. Index funds are easy to invest in, and can also be extremely inexpensive. They let you earn the market's return without having to decide which individual stocks to buy or sell, and when to do so. And a broad-market index fund also features a dividend yield.

Is that such a big deal? Well, yes. Many investors don't know this secret, but between January 1926 and December 2006, 41% of the S&P 500's total return was derived from dividends, as opposed to stock price appreciation. And thanks to our current recession, dividends right now are especially attractive. The dividend yield on the S&P 500 index fund is around 3.4%. Does that number seem familiar? That's right -- it's close to the historical average inflation rate. If you buy into an index fund today and it pays a 3% yield, you stand a good chance of offsetting much or all of the inflation coming your way.

The S&P 500's dividend yield was below 2% less than two years ago, and around 1% back in 2000.

Individual stocks
You can fight inflation with individual stocks, too, as many of them also offer dividend yields, plenty of which are well above 3% these days. For example, here are some large-cap stocks with yields topping 4% that have also earned high ratings from our Motley Fool CAPS community of investors:

Source: Motley Fool CAPS.

Beyond dividends, stocks offer an additional edge against inflation: When faced with rising costs of materials or other inputs, many companies can simply hike the prices they charge their customers. So they become a participant in our national inflation, rather than a victim of it. Bonds with fixed interest rates are not so flexible. A five-year CD isn't going to suddenly increase the interest it pays you if inflation rises. Stocks carry a nice inflation-fighting advantage.

What to do
Inflation will have an effect on almost every financial aspect of your life -- even your mortgage. For example, if you lock in a 30-year, 6% mortgage with $1,000-a-month payments, as inflation over time makes the dollar worth less and less, your payment is essentially lower and lower. You might be earning $50,000 now, and paying that $1,000, but in 15 years if you're earning $75,000 or $100,000, that $1,000 payment will represent a much smaller chunk of your wealth.

So as you go about your life, tending to your finances, keep inflation in mind. Consider stocks and dividends for your portfolio, and if you're looking at bonds, consider ones that factor in inflation, such as TIPS.

Learn more in these articles:

• Stocks to Fight the Coming Inflation Wave
• Will Inflation Kill Your Stocks?
• Hyperinflation Is U-G-L-Y