A penny might not seem like much, but pennies add up. Lose two out of every dollar and in 50 years you'll have nothing.

To put it more concretely: If you lose 2% of your savings each year to inflation, you could be caught short in retirement.

Inflation of bagels and coffee

Inflation is the steady increase in prices that affects you each time you go to a grocery store, fill up your car's gas tank or buy a winter coat. It's the biggest investment risk most people face. If your investments earn less than the rate of inflation, your money will buy less in the future than it does now.

"Of all the real threats to one's standard of living, inflation is perhaps the most overlooked," says Jose Rubio of Rubio Wealth Management in Coral Gables, Fla.

You may think of inflation as a 1970s fad, like mood rings and the Pure Prairie League (for you relative youngsters, that's a band that was big then), but it's always with us.

"Inflation is not something you just worry about at the peak of the business cycle. It's something investors have to worry about at all time," says Robert Dieli, the president of RDLB, an economics consulting firm in Lombard, Ill.

"Inflation is the silent killer"

The most common measure of inflation in the United States is the federal government's Consumer Price Index. The index is calculated by looking at the prices of more than 200 specific items, ranging from apples to women's dresses. If your needs and preferences differ from those reflected in the list, your actual expenses may be higher or lower. Take the cost of a college education, for example. Dieli notes that "the rate of inflation for education is higher than the rate of inflation in general."

How the CPI applies to you

For protection, add risk

To plan well for the long term, you need to take the risk of inflation into account.

Want to protect against that long-term risk? One good strategy is to add investments that come with other kinds of risk -- more of the short-term variety.

Take the stock market. Stock prices tend to fluctuate quite a bit over the short term, but, historically, they tend to beat the rate of inflation. That's because companies can compensate for inflation.

"As inflation goes up, presumably the corporation can raise its selling prices to incorporate the higher costs of doing business," says Paul Kasriel, the chief economist at Chicago investment management company Northern Trust.

Playing safe isn't really safe

On the other hand, some seemingly safe investments, such as bank accounts and bonds, carry tremendous inflation risk because their returns are usually in line with expected inflation.

"If you are a bondholder and there is unexpected higher inflation, that means you lose," Kasriel says. "You are getting paid back in dollars that are not worth as much."

Kasriel points out that unexpected inflation is a much bigger problem for investors than expected inflation. Today, a modest rate of inflation is factored into most investments. But rates of return are often rigid. When inflation rises unexpectedly, those rates don't adjust, and investors are stuck.

Play commodities as a hedge

Investments in commodities are another way to hedge against inflation.

"Oftentimes, inflation is accompanied by higher commodity prices," Kasriel says. "If one is anticipating high inflation, commodities are a natural place to preserve your purchasing power."

Rubio agrees. "Rising commodities prices are the very definition of inflation," he says. He recommends that investors worried about inflation consider measured commodities investments, particularly exchange-traded funds designed to reflect the price of different commodities. He warns, however, that new commodity investors should go slowly.

"The average investor starting out should strongly consider attending seminars and workshops before investing in commodities, and be wary of any person or company that promotes any get-rich-now scheme," he says.

Commodities also make a good hedge against exchange rate fluctuations, which are influenced by inflation, Kasriel says. He explains that if a foreign currency appreciates against the U.S. dollar, then it will take more dollars to buy the same foreign goods. "The dollar price of commodities tends to rise as the dollar falls. If you expect that the dollar is going to decline, you can buy commodities as a partial hedge."

Chart: US dollar vs foreign currencies

Another way to protect against exchange-rate driven price changes, Kasriel says, is to invest in U.S. companies with foreign operations.

Chart: America's dollar doldrums

If inflation is bad, wouldn't it be better if costs went down? That's a situation called deflation, and "it's not something we want to think of as desirable in any sense," Dieli says. "Prices relate to income. If prices are falling, then income is almost always falling. And if income is falling, employment is falling."

Because deflation is big trouble for the economy, government officials guard against it. Generally speaking, you don't want to bet against the government. In other words, it's better to invest with inflation in mind than to bet against it.

Published July 24, 2008