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For some people, the goal of investing is not so much getting ahead as it is not falling behind. Because inflation marches forward each and every year, the fear is that your buying power will diminish if your investments don't appreciate as quickly as the cost of what you buy.
Theoretically, there's a risk of deflation too, but economists tend to agree that it's not likely. There's also a fear among some that the U.S. dollar could simply become worthless someday, whether because of hyperinflation or some other reason.
Most savings can be eaten up by inflation. Bonds and bank deposits are particularly vulnerable. Because companies can raise prices, maintain profits and adapt to market conditions, the stock market has kept up with inflation and, in fact, has beaten it over long periods. But inflation is no friend to stocks; severe inflation damages the economy and thus companies too.
There are two types of investments that are traditionally favored as inflation hedges: precious metals and real estate. And there's one fairly new investment vehicle, "inflation-indexed securities," that the U.S. government created last year to address inflation fears directly.
* Precious metals. If you talk to "gold bugs," they will tell you that gold--the bellwether of precious-metal investments--holds its value over time. An ounce of gold would buy you a suit of clothes in the days of Henry VIII and it would still buy you a suit of clothes today.
What they won't tell you is that while inflation has risen 3.1% per year, on average, since 1925, the value of gold--which became publicly available in the U.S. only in the late 1970s--has fallen from about $800 per ounce in 1980 to about $344 by the late 90s.
Of course, if you are luckier with the bets, you can make money this way or in gold-mining stocks as well. But do you want an inflation hedge or are you a speculator?
Besides the short-term risk, there are other disadvantages to buying gold. Namely, if you buy gold bullion or coins, you must store them somewhere--like a bank safe-deposit box. And a box is likely to run you $40 to $50 a year. Also, gold doesn't pay dividends, it doesn't pay interest--it just sits there. In a box. In the bank. In the dark.
It's tough to justify buying bullion unless you are convinced of some doomsday scenario. And it isn't entirely clear that gold will be useful if the world turns to total chaos.
* Residential real estate. Your home can provide a real hedge against inflation no matter what happens to the price of your house in the future.
How so? By buying a home that you can live in, you eliminate the need to pay rent. That protects you from possible rental-rate increases. You also get some tax benefits when you buy residential real estate, so your out-of-pocket cost--or after-tax cost--may be less than the sum total of your down payment and total monthly payments.
And if you have a fixed-rate mortgage, you have stopped the progress of inflation on one of the biggest items in your personal budget: housing expenses. Your mortgage payment, if you choose to stay in your home and don't refinance, will be the same today as it is 10 years from now and 25 years into the future. At the end of the 30 years, your personal inflation rate will drop because your mortgage will be paid off and you will be living in your home rent-free. (Naturally, you'll still have to pay property taxes, insurance and maintenance costs, but those are likely to be significantly less costly than rent.)
National statistics that track changes in the sales prices of residential real estate are somewhat dubious because they don't attempt to determine the size and quality of the residences sold in any given period. Today's average home is larger than the average home sold in the 1950s, which means some of the "appreciation" in the residential housing market is really paying more for more house. However, average real estate prices do appear to rise over long periods and, in recent decades, faster than the rate of inflation.
If you subscribe to the doomsday theory--its proponents usually advocate gold as an investment, thinking that inflation will be so high that U.S. currency will become worthless and we'll all be driven to barter to survive--remember that you can't eat gold. But you can grow vegetables in your backyard.
* Inflation-indexed securities. In the late 1990s, the U.S. Treasury introduced a type of government-backed bond that will pay a return that's pegged to increases in the consumer price index.
These bonds pay a current return--roughly 3.5% today--and once a year the bonds' principal value will be adjusted to reflect hikes in the index. Your future interest payments on these "real-return" bonds will be pegged to the boosted principal value.
Let's say you bought a $1,000 bond. You earn $35 in interest on it. At the end of the year, the index indicates that inflation rose 4%. The principal value on your $1,000 bond is hiked to $1,040. The following year, your interest payments will rise to $36.40 to reflect a 3.5% return on your $1,040 principal value.
The only catch: If your bonds are not in a tax-favored retirement account, both the interest and the inflation adjustment are taxable. So, you pay income taxes on both the interest and the $40 boost to the principal value, even though you didn't receive the $40 in cash.
Still, what real-return bonds offer that other inflation hedges don't is true efficiency. The value of this investment really does rise in lock-step with the rate of U.S. inflation as measured by the consumer price index. If inflation is one of your major concerns, and you're not the home-owning type, these bonds are worth considering.
Theoretically, there's a risk of deflation too, but economists tend to agree that it's not likely. There's also a fear among some that the U.S. dollar could simply become worthless someday, whether because of hyperinflation or some other reason.
Most savings can be eaten up by inflation. Bonds and bank deposits are particularly vulnerable. Because companies can raise prices, maintain profits and adapt to market conditions, the stock market has kept up with inflation and, in fact, has beaten it over long periods. But inflation is no friend to stocks; severe inflation damages the economy and thus companies too.
There are two types of investments that are traditionally favored as inflation hedges: precious metals and real estate. And there's one fairly new investment vehicle, "inflation-indexed securities," that the U.S. government created last year to address inflation fears directly.
* Precious metals. If you talk to "gold bugs," they will tell you that gold--the bellwether of precious-metal investments--holds its value over time. An ounce of gold would buy you a suit of clothes in the days of Henry VIII and it would still buy you a suit of clothes today.
What they won't tell you is that while inflation has risen 3.1% per year, on average, since 1925, the value of gold--which became publicly available in the U.S. only in the late 1970s--has fallen from about $800 per ounce in 1980 to about $344 by the late 90s.
Of course, if you are luckier with the bets, you can make money this way or in gold-mining stocks as well. But do you want an inflation hedge or are you a speculator?
Besides the short-term risk, there are other disadvantages to buying gold. Namely, if you buy gold bullion or coins, you must store them somewhere--like a bank safe-deposit box. And a box is likely to run you $40 to $50 a year. Also, gold doesn't pay dividends, it doesn't pay interest--it just sits there. In a box. In the bank. In the dark.
It's tough to justify buying bullion unless you are convinced of some doomsday scenario. And it isn't entirely clear that gold will be useful if the world turns to total chaos.
* Residential real estate. Your home can provide a real hedge against inflation no matter what happens to the price of your house in the future.
How so? By buying a home that you can live in, you eliminate the need to pay rent. That protects you from possible rental-rate increases. You also get some tax benefits when you buy residential real estate, so your out-of-pocket cost--or after-tax cost--may be less than the sum total of your down payment and total monthly payments.
And if you have a fixed-rate mortgage, you have stopped the progress of inflation on one of the biggest items in your personal budget: housing expenses. Your mortgage payment, if you choose to stay in your home and don't refinance, will be the same today as it is 10 years from now and 25 years into the future. At the end of the 30 years, your personal inflation rate will drop because your mortgage will be paid off and you will be living in your home rent-free. (Naturally, you'll still have to pay property taxes, insurance and maintenance costs, but those are likely to be significantly less costly than rent.)
National statistics that track changes in the sales prices of residential real estate are somewhat dubious because they don't attempt to determine the size and quality of the residences sold in any given period. Today's average home is larger than the average home sold in the 1950s, which means some of the "appreciation" in the residential housing market is really paying more for more house. However, average real estate prices do appear to rise over long periods and, in recent decades, faster than the rate of inflation.
If you subscribe to the doomsday theory--its proponents usually advocate gold as an investment, thinking that inflation will be so high that U.S. currency will become worthless and we'll all be driven to barter to survive--remember that you can't eat gold. But you can grow vegetables in your backyard.
* Inflation-indexed securities. In the late 1990s, the U.S. Treasury introduced a type of government-backed bond that will pay a return that's pegged to increases in the consumer price index.
These bonds pay a current return--roughly 3.5% today--and once a year the bonds' principal value will be adjusted to reflect hikes in the index. Your future interest payments on these "real-return" bonds will be pegged to the boosted principal value.
Let's say you bought a $1,000 bond. You earn $35 in interest on it. At the end of the year, the index indicates that inflation rose 4%. The principal value on your $1,000 bond is hiked to $1,040. The following year, your interest payments will rise to $36.40 to reflect a 3.5% return on your $1,040 principal value.
The only catch: If your bonds are not in a tax-favored retirement account, both the interest and the inflation adjustment are taxable. So, you pay income taxes on both the interest and the $40 boost to the principal value, even though you didn't receive the $40 in cash.
Still, what real-return bonds offer that other inflation hedges don't is true efficiency. The value of this investment really does rise in lock-step with the rate of U.S. inflation as measured by the consumer price index. If inflation is one of your major concerns, and you're not the home-owning type, these bonds are worth considering.
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