Inflation and Your Stock Portfolio

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Source: http://www.flickr.com/photos/craighatfield/

Source: http://www.flickr.com/photos/craighatfield/

Inflation is a fact of life. The Federal Reserve continuously increases the monetary base, which in turn leads to an increase in the amount of dollars in the economy. This means it takes more dollars to buy the same amount of goods over time. While this makes investing more difficult, those investors who see it coming will be better positioned to prepare their portfolios to generate returns that exceed the inflation rate, and these investors will prosper in the long term.

In order to be a successful investor, you have to generate returns that exceed the rate of inflation. This is more difficult than it might seem. If you wish to beat the rate of inflation as an investor, you need to do better than simply generating a return that outpaces the inflation rate.  This is somewhat counterintuitive. People think that if the inflation rate is 10 percent, then they need to earn at least 10 percent on their money  in order to beat inflation. But it is more complicated than this.

If the inflation rate is 10 percent, you need to generate returns that exceed 10 percent. If the inflation rate is 10 percent, this means that if you have $100 today and you generate no return, then the $100 loses 10 percent of its purchasing power. So its purchasing power in a year will be equivalent to just $90 of purchasing power today. If you earn 10 percent on your $100, then in a year it becomes $110. But since dollars lost 10 percent of their value your $110 a year from now is worth just $99 today.

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