The value of our dollars cannot and will not remain the same because of inflation. The changing value of the dollar can only be understood in terms of the ability to exchange that dollar for a product or a service. When inflation increases there's a resultant decrease in the purchasing power of that dollar. It's worth less. For example, if the inflation rate is 5% this year, the things that you buy today will cost $1.05 next year, and as a result, that dollar you have today won't be worth a dollar next year. Its value has shrunk. That initially seems counterintuitive, but with a little thought, it's true. Investors today need to find a way to make today's dollar worth $1.05 next year just to preserve their purchasing power. And then they have to find a way to make even more the next year.
So when we think about inflation and investing, the question on many investors' minds is "How will inflation affect my investments?" This is an especially important issue for people living on a fixed income, such as retirees. For the most part an investor needs to stop thinking about the nominal increases in their portfolio and start thinking about the inflation adjusted increases in their portfolio. And as ironic as this seems, if you simply want your wealth to remain the same (in terms of purchasing power), you'll have to increase it (at the rate of inflation) over time.
The good news is that for most equity investors, the impact of inflation may be minimal but it generally depends on the type of securities they hold. If an investor owns mostly common stocks of great growth companies with increasing dividends, he won't have to worry much because these types of stocks usually increase faster than inflation over time. If, however, an investor invests primarily in bonds or Certificates of Deposit (CD), he had better understand the bond's coupon rate or the CD's earned interest in relation to the consumer price index or inflation rate. A coupon rate less than inflation will be disastrous to his accounts, and an investing mistake of this kind can undo a lifetime of savings.
As can be seen in the graph below the latest annual inflation rate for the United States is 1.7% through the 12 months ended August 2014, as published by the US government on September 17, 2014. It should be mentioned that the Federal Reserve (which controls the nation's money supply and arguably influences the nation's rate of inflation) tries to target a 2% inflation rate, so you can assume that a 2% inflation rate is going to have to be built into your investment plans. However, the Federal Reserve often over or underestimate the effects their actions will have on the economy and the resultant inflation often varies significantly (see below).
Unfortunately very few adults understand investments, inflation, wealth accumulation and purchasing power. A lot of adults simply place their money in regular savings accounts or CDs. While these are worthwhile places to store money that may be needed in the short term, they'll less desireable for long term investments.
If you're like me you've seen advertisements like the one below displaying information about savings accounts that pay 0.95% APY or CDs that pay 1.20% to 2.30%. When compared to the graph above, these rates are awful. They pale in comparison to today's inflation rate of 1.7% or those inflation rates as high as 4.1% during the last 10 years.
If this realization doesn't convince the average adult to seek out better investments then no argument ever will convince them. For me, these rates led to an interest in stocks that grow over time, pay dividends, and grow their dividends over time rather than savings accounts and CDs. It made me realize that I needed to invest in American companies that were growing their revenues, earnings and dividends at a rate in excess of inflation. It led me to the Dividend Aristocrats. And then to the Dividend Kings. And then to the Dividend Champions.
I want to invest in companies that will continually increase in value faster than the rate of inflation and hence, not only preserve my purchasing power, but actually increase my purchasing power over time. I want to be making more money in the future and have greater purchasing power in retirement than I did during my working years. And the only way I know of doing that is to invest today's dollars in companies that grow their revenues, earnings and dividends.