You might be the kind of person who wants to let your money do some of the work of growing for you. However, if your money is not earning enough to beat inflation, you might lose money rather than make it. Inflation is the rise in the cost of goods and services over time and can eat away at your savings.
The Federal Reserve works to keep the rate of inflation around 2% per year. With that in mind, your assets should earn at least that much (more is even better) to hold their value. Find out how to beat this value-stealer with mutual funds and ETFs.
- Taxes and inflation eat into the earning power of your investments.
- Diversifying your portfolio with different types of mutual funds and ETFs can help you keep up with inflation.
- Consider including growth stock funds, foreign stock funds, and bond funds in a diverse portfolio.
Your Money and the Average Rate of Inflation
As measured by the Consumer Price Index (CPI), the average rate of inflation over the last 10 years, it has averaged a little under 2%. But the inflation rate can change every month depending on the conditions prevalent in the economy. For example, in October 2021, the inflation rate spiked to 6.2% while earlier in the year in March it was merely 2.6%.
So how does inflation affect your money? For example, you have a certificate of deposit (CD) that gives you 1% interest and the average annual rate of inflation for the year was 3%. After doing some quick math, you see that your money would actually lose 2% of its value for the period (1% CD interest - 3% inflation = -2%). In other words, you'd actually fall behind due to inflation.
This still doesn't yet account for taxes owed on your interest income. Taxes would reduce your nominal interest rate (before inflation) to 0.76%, assuming a federal income tax rate of 24%. That would make your inflation-adjusted loss -2.24%! So, in a relatively low-interest rate market, you could save money in a CD but still lose value because of inflation and taxes. Some call that "losing money safely."
The best way for most people to beat inflation is to achieve returns that average more than the average inflation rate leaving some room for taxes. The most common way for you to do that is to invest in a combination of stock and bond mutual funds.
Beat Inflation With a Portfolio of Mutual Funds and ETFs
Making a portfolio of mutual funds and exchange-traded funds(ETFs) is similar to building a house. There are many ways to do it. People have their own strategies, designs, tools, and building materials they prefer. In the end, all structures share some basic features and tend to function the same.
To build a portfolio of mutual funds to grow your money, you must go beyond the sage advice of not putting all of your eggs in one basket. A structure that can stand the test of time needs a smart design and a strong foundation.
The total return of your portfolio is how you beat inflation, not the return of one fund or a few stocks.
You also need a simple combination of mutual funds and ETFs that can work well for your needs. In this case, "simple" means a few funds that compliment each other instead of many funds that are almost the same.
Learn How Diversification Really Works
Diversification with mutual funds and ETFs is more than just putting your eggs into lots of baskets. Many investors make the mistake of thinking that spreading money among several mutual funds means they have a diversified portfolio. However, "diverse" doesn't mean "different." Be sure you have exposure to the various types of mutual funds and ETFs.
For instance, if you place funds in the Vanguard 500 Index Fund Admiral Shares, you'd gain access to Apple, Microsoft, Amazon, and Google. You could then choose a different fund, like the Fidelity 500 Index Fund. You'd receive more shares of Apple, Microsoft, Amazon, and other stocks; however, you'd be buying more shares of the same stocks that are on the same index.
To achieve more diversity, you might consider SPDR Portfolio S&P 1500 Composite Stock Market ETF that gives yo exposure to more than 1,500 U.S. companies across sectors and market capitalization. Such broad diversification can help offset any negative impact that inflation may have on certain companies or sectors through gains achieved by others who benefit from higher prices.
Choose Growth or Foreign Stock Funds and ETFs
As the name implies, growth stock mutual funds and ETFs tend to perform best in the mature stages of a market cycle when the economy grows at a healthy rate. The growth plan reflects what corporations, consumers, and investors are all doing simultaneously in good times. They expect higher future growth and spend more money to make sure it happens.
Foreign stocks can be risky, so you'll need to make sure you're choosing funds that reflect indexes from countries that are doing well.
When inflation rises, the value of the U.S. dollar may fall. Foreign stock funds and ETFs can act as a hedge (an asset that works to reduce total losses) as money placed in foreign assets can translate over time into more dollars at home.
Use Inflation-Beating Bond Funds and ETFs
Bonds can lose value when inflation rises, because bond prices move opposite the path of interest rates. Interest rates tend to rise with inflation. However, there are ways to use bonds, bond funds and ETFs to invest when inflation is rising.
Rising inflation makes the prices of bonds go down. The longer a bond's maturity, the farther prices can fall. Therefore, bonds with shorter maturities will do better when rates are rising. Keep in mind that short-term bonds may be a good choice for short-term plans when rates are climbing. However, they might not beat inflation in the long run. You may need to get in and out of short-term bonds as things change.
Although the maturities are longer with these funds, no one knows what interest rates and inflation will do. Even the best funds can be wrong from time to time about where interest rates and inflation are headed.
Also known as Treasury Inflation-Protected Securities (TIPS), these bond funds can do well before and during times when inflation rises. Often, the rise coincides with climbing interest rates and growing economies.
Mutual funds and ETFs are one of the best ways to beat inflation for most investors. Stock funds can provide you with greater long-term returns, because they tend to return more than the rate of inflation. However, they have a greater risk of causing you to lose your principal than bonds themselves or bond funds.
Frequently Asked Questions (FAQs)
What does inflation do to the stock market?
Inflation's impact on the stock market isn't uniform. Some inflationary impacts are good for some stocks and bad for others. The same company might benefit from inflation in some ways and be hurt by it in others. The dollar figure for earnings may increase with inflation, for instance. The cost of debt will also rise with inflation, and this could hurt growth companies with large amounts of debt on their balance sheet.
How much does the stock market grow each year on average after accounting for inflation?
The S&P 500 has grown by roughly 10% annually since the early 1990s. When you consider that the Federal Reserve maintains an inflation target of 2%, you could say that the stock market grows an average of 8% per year after inflation. However, both inflation and stocks are highly volatile, and these averages can oversimplify what it feels like to hold stocks through market crashes or try to make ends meet during periods of high inflation.