The Invisible Tax: Inflation and Its Effects

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Investing 101

A rose by any other name might still be a rose, but what about a dollar? Is the worth of a dollar today the same as it was back in, say, 1970? Or, for a sweeter example, what about the price of a can of Coke? In 1974, a glass bottle of Coke was $0.10. Today, a can of Coke will cost you around $1.20. Why the price change? In one word: inflation. From a can of Coke to your investment portfolio, inflation leaves no survivors in its wake.

Over time, inflation can chip away at a seemingly solid portfolio leaving investors with far less of a return than was originally estimated. Often compared to an invisible tax or a stealthy thief, inflation is an unavoidable risk that will weigh down your portfolio return.

How Fast Is Your Portfolio Really Growing?

To keep up with the inexorable march of inflation, investment returns must stay above inflation rates. Historically, inflation rises approximately 3% (give or take) within the United States annually. Thus, an investment that is expected to produce a 3% return will actually net you nothing once you account for the invisible tax.

The problem is that most investors don’t realize how much inflation is impacting a portfolio until it’s too late. Boardwalk Empire’s clever bootlegger Chalky White can teach investors a thing or two about inflation. Much like the watered down booze that White attempted to pass off as pure liquor was met with hostility, inflation exists undetected until it’s too late (episode synopsis here). As is the case when buying liquor-flavored water, inflation is an investment risk.

Inflation might also be the one thing that is impervious to Newton’s law of gravity. What goes up rarely goes down; the last extended period of deflation in the United States was at the beginning of the Great Depression. Crossing your fingers and hoping that your investments aren’t impacted by inflation is not a good way to play the game. But knowing about inflation and its risks is more than half of the battle. Armed with this knowledge, it is possible to attempt to protect your investments from inflation.

A Pro-Active Approach to Inflation

The fight against inflation is an uphill one, but going the pro-active route can help. In addition to balancing your portfolio through diversification, there are some tactics that might be solid weapons against inflation’s impact.

Investing in Treasure Inflation Protected Securities (TIPS) is one such method. These securities have been historically proven to withstand market collapse by acting as a portfolio protecting investment – much like Captain America, they’re solid, dependable and protect against danger. (For more Avengers investment analogies, check out this super article).

Another way to protect your portfolio from inflation’s impact is to consider investing in a REIT ETF (Real Estate Investment Trust/Exchange Traded Funds). REIT revenues adjust according to changes in cost of living. This provides investors with solid returns in the wake of inflation due to the correlation between replacement cost and market value. In addition, REITs also guarantee a certain number of dividend payments regularly, and that’s always a good thing.

In the end, asset allocation will protect your well-diversified portfolio (including equities, TIPS, and REITs) from inflation’s stealthy impact. While not a tax in the literal sense of the word, inflation does gnaw at investment portfolios making it a notion worth knowing all about.

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