The main effect that inflation has on investments is that it destroy their value. The way inflation destroys is obvious: it decreases the spending power of money. A higher rate of inflation will mean that your investments will be worth less. Both the principal and any earnings will fall in value because of it.
Inflation affects different investments differently it often has a more destructive effect on fixed vehicles and less impact on flexible investments. Something to remember is that there is no such thing as an inflation-proof investment. Anything that you put your money into can be undermined and potentially destroyed by it.
Inflation and Fixed Rate Investments
Inflation has the biggest impact on fixed rate investments such as fixed annuities, bonds, money market accounts and savings accounts. The reason the impact is greater is that the rate of return on these vehicles is often lower than the rate of inflation. If the rate of inflation is higher than the return the investment will lose money.
For example if an annuity pays 2.5% and the yearly inflation rate is 4%, the annuity will actually lose 1.5% of its value in the year. The longer inflation lasts the more it will undermine the annuity. It can be particularly destructive to annuities that pay out a fixed payment because the funds will simply buy less.
Beating Inflation with Indexes
There are investments that are designed to have a return that is considerably higher than the rate of inflation. This includes investments pegged to the stock market including indexed annuities and universal life insurance polices. These vehicles are partially invested in an index of stocks.
The rate of return on stock market indexes like the S&P 500 is historically between 10% and 15%. This is usually around 10% higher than inflation so it usually beats inflation. Such investments are vulnerable to stock market losses though. These instruments usually employ strategies such as diversification and guaranteed rates of return to overcome inflation.
Diversification means that the instrument is invested in a wide variety of equities so it will not suffer losses because of a bad stock pick. A guaranteed rate of return is a mechanism that locks in higher returns so the rate of return will not fall below inflation because of a bear market. An indexed annuity will often employ both of these strategies.
Inflation and Bonds
Not surprisingly bonds are one of the most vulnerable investments to inflation. US treasury bonds are considered one of the safest investments and easiest for average persons to access. They have also been one of the most vulnerable to inflation because of the low interest rates.
This is why many investors have turned to higher risk corporate and other private offerings that have higher returns. The US Treasury Department recognized this and created TIPS or Treasury-Inflation Protected Securities. The principal of TIPS is designed to rise and fall with inflation in an attempt to compensate for inflationary losses. This provides protection but it also has some drawbacks the IRS considers rises in TIPS principal in income and taxes you for them.
Alternatives to treasury offerings including bond funds which are designed to offset inflationary risks. Many of the bond funds come with higher operating costs and slightly greater risks because they are invested in private offerings.