Money Essentials

Understanding how inflation works

Most people think a market crash is the biggest danger to investors. Wrong.

Let's say the market takes a 30% dive over the next year. Every time you check your stocks or stock mutual funds, you're going to feel the pain. Likewise, if interest rates rise, your bonds won't let you forget it.

Nowhere on your bank or brokerage statement, however, are you likely to get a report on what inflation is doing to the real value of your holdings. If your money is stowed in a "safe" investment, like a low-yielding savings or money market account, you'll never see how inflation is gobbling up virtually all of your return.

Here are some points to bear in mind:

- At an average annual growth rate of 9.8% a year, stocks will double your money in a little over seven years. Factor in inflation, which has historically run at about 3% annually, and it will take more than 10 years to double your actual buying power.

- Likewise, bonds, which have historically grown at roughly 5.4% annually, will double your money every 12 years. After inflation, however, it will take 26 years.

- If your money is in cash, you'll have to wait 23 years for the nominal value of your account to double, assuming the cash earns the historical 3% annual return. But even your grandchildren won't see the real value of your money double.

That's why, whenever you add up your gains or losses for a given period of time, you have to add in the effects of inflation to understand how much further ahead or behind you really are. Top of page

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Updated 7/10/2012 with updated content, link - aross