Investments to Fight Inflation

Inflation can eat away at the value of your money -- and threaten your financial future.

At 3% on average over the long haul, inflation can turn a seemingly sizable nest egg into just a few bites' worth of omelet; what costs you $100,000 now will cost $240,000 in 30 years at that seemingly meager rate. Even in the short run, 3% inflation turns a 10% return on your investment into a "real" return of less than 7%.

Worse yet, the ongoing economic crisis could turbocharge the rate at which your savings erode. It's possible -- though far from certain -- that all the stimulus money we've pumped into our economy could eventually lead to higher inflation. If you leave a lot of money in cash, its true buying power will shrink year by year, even if the actual amount remains the same. Even leaving long-term money in a bank account can be disastrous, if the rate of interest you're earning can't keep pace with expanding inflation.

Fortunately, there are several ways to beat this creeping menace at its own game.

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 they're often extremely inexpensive. They let you earn the market's return without having to decide which individual stocks to buy or sell, or when to do so.

A broad-market index fund will also give you some sort of dividend yield. Many investors don't know this secret, but over the long haul, more than 40% of the S&P 500's total return has come from dividends, as opposed to stock price appreciation. Dividend stocks can be attractive investments, especially in times of uncertainty.

The dividend yield on the S&P 500 index fund currently hovers around 2%. That's not terribly high, but it's better than the 1% yield the index generated back in 2000.

Individual stocks
Many individual stocks also offer dividend yields, plenty of which far exceed 4% these days. These large-cap stocks sport yields topping 4%, and have also earned high ratings from our Motley Fool CAPS community:

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. That makes them participants in our national inflation, but not victims of it.

Although some bonds do offer inflation protection, those with fixed interest rates are not so flexible. A five-year CD won't to suddenly increase the interest it pays you if inflation rises. In general, the ability to roll with the pricing-power punches gives stocks a definite advantage as inflation-resistant investments.

Inflation-protected bonds are useful, but they're not invulnerable. Find out why TIPS aren't bulletproof.