| Inflation refers to the general increase in prices as | | | | In an attempt to control inflation, regulatory |
| a result of the influence of the money supply or | | | | bodies may raise or lower lending rates in order |
| supply of goods. It is essentially a relationship | | | | to discourage borrowing. However, interest rates |
| between the quantity of money and productive | | | | in periods of high inflation would increase in order |
| growth. Inflation is not simply a general increase in | | | | to make investing more attractive than spending. |
| prices. Overall price increases could arise as a | | | | 4) Financial instruments |
| result of other economic and social factors. | | | | Some investment-types actually benefit from |
| Disinflation and deflation are concepts that arise | | | | inflation. These would include higher-order |
| from the initial concept of inflation. Disinflation | | | | investment instruments like real estate and art |
| refers to a reduction of the inflation rate or a | | | | for example. With these instruments, higher |
| slowing of inflation. Deflation is the polar opposite | | | | inflation would increase the absolute returns |
| of inflation. It refers to a contraction in the | | | | significantly. The opposite happens to cash and |
| money supply or a general reduction in prices as a | | | | income instruments like fixed deposits and money |
| result of the contraction. Inflation is usually seen | | | | market funds. Cash and income options are less |
| as necessary for economic growth. However, too | | | | inimical to your savings and investments in |
| much of one thing is good for nothing. Even so, | | | | low-inflation periods. |
| high inflation benefits some investors more than | | | | In the same way, inflation does not affect all |
| others. | | | | investments similarly. Investments in items that |
| Inflation is important in considering one's financial | | | | have intrinsic value, like gold or art would actually |
| future in four main ways: | | | | thrive in inflationary periods due to their |
| 1) The real return of return of an investment | | | | uniqueness. This means that the aggregate |
| The real rate of return is the nominal rate of | | | | demand for these would remain substantial since |
| return discounted for inflation. One school of | | | | more money would chase a fixed quantity. |
| thought is that it is the combined effect of taxes | | | | Investment classes like cash or bonds and other |
| and inflation has a more debilitating effect than | | | | financial instruments that are indexed to |
| inflation risk solely. For example, with deferred | | | | dollar-value perform badly in periods of high |
| annuities, tax is paid at maturity. The returns | | | | inflation. Common stocks thrive in periods of |
| from an annuity can be discounted for inflation. | | | | moderate inflation. |
| However, taxation would be levied against the | | | | Understanding inflation would help us to |
| projected nominal return during the payout phase. | | | | understand the importance of diversifying our |
| That would reduce the overall return of taxable | | | | portfolios sufficiently to include growth and income |
| investments. | | | | investments. Higher-risk investments limit both |
| 2) Purchasing power risk | | | | purchasing power risk and inflation risk. |
| This risk arises because of the impact of inflation. | | | | Investments in annuities must be made after |
| Since inflation reduces the nominal returns from | | | | considering the dual combination of inflation risk |
| investments, the purchasing power of capital may | | | | and taxation that reduce future returns. Knowing |
| decline with certain investments. | | | | the inflation risk with various financial instruments |
| 3) Interest rates | | | | can only benefit the investor. |