You may think you have a lot of reasons to stay out of the stock market. Maybe you’re wary of Wall Street. Maybe you've watched stock prices jump around and decided you’d rather not go on that ride. Or maybe you're scared of losing your hard-earned money to something you don’t really understand.
Whatever concerns you might have about the market, there’s one big reason to stick with stocks: inflation.
What’s inflation again?
It's the unfortunate phenomenon of prices going up, which in turn causes the value of our hard-earned dollars to go down. In recent years, inflation’s been pretty low, averaging 1.26 percent in 2016, based on the year-over-year change in the Consumer Price Index, which tracks prices for common items from gas to ground beef. But it’s been on the rise, climbing to 2.5 percent in January (from January 2016).
How does that translate to what we’re spending? A gallon of milk that cost $3.07 in January 2007, for example, cost $3.32 in January of this year. And coffee went from an average of $3.29 to $4.47 per pound in the same period.
Why do prices go up?
It’s mostly about supply and demand. High demand for products, as well as a low supply of products, will push prices higher. Also, if our country’s money supply were to go up—either via our central bank, the Federal Reserve, or due to rising wages—it could also boost inflation. (More money in circulation means more money to spend means more demand for products.) If production costs were to rise, companies might also increase prices to compensate.
Companies can raise prices arbitrarily, too, but the competition inherent in our capitalistic system provides limits there.
What does all this have to do with investing?
Inflation’s effects on your spending are probably clear: higher inflation = lower purchasing power = hello, tighter budget. One way to overcome that is by investing. “In other words, if we do nothing and sit on the sidelines when it comes to investing, we are, in fact, losing money,” says Certified Financial Planner Vid Ponnapalli.
For example, if you were to stuff $1,000 under your mattress, assuming the average inflation rate of 3.25 percent, that money would be worth just $726 in 10 years. Just to maintain the $1,000 value, you’d have to earn at least 3.25 percent on your savings. Considering that the best savings accounts are offering 1.35 percent yields now, according to Bankrate (and most are offering far less), one of the only ways to keep up with inflation is to invest in stocks.
But investing is risky, too...
Which is why it’s important to build a well-diversified portfolio with a mix of stocks and bonds, and also small-, mid- and large-cap company stocks in a variety of sectors. Investing in funds, like exchange-traded funds (ETFs) is a relatively low cost way to gain exposure to hundreds of different stocks at once.
Anything else I should know about inflation?
Remember that inflation can vary for different types of expenses. For example, when Certified Financial Planner Marguerita Cheng accounts for inflation in her clients’ financial plans, she assumes a 3-percent inflation rate in general, but a 7-percent increase for college costs. (Ouch.) And she adds retirement healthcare costs as a separate line item altogether.
So take your personal situation into account, and do some research, when you’re figuring out how much to save and invest and thinking about how inflation may affect you.