Inflation is something that every investor should know about. The wise investor understands how inflation erodes their purchasing power and he or she takes steps to mitigate the damage.

Inflation is when the price of goods and services rises at a rapid rate. This destroys your purchasing power. Ever heard that a dime doesn’t go as far as it used to? That is due to inflation.

In theory, stocks are able to take handle the effects of inflation. This is because revenue and earnings usually increase at the same pace. However, for this to happen prices have to rise. Many companies face global competitors that offer different inflationary pressures, which prohibits the increase in prices at a rate to keep up with domestic inflation. In other words, not every company can afford to increase the prices for their goods and services.

When the economy is looking at inflation, the Fed usually increases interest rates to slow growth. This cools off the economy, but isn’t the best news for companies. Higher interest rates entice consumers to reduce spending, which takes money away from many sectors.

Stocks are often toted as good protection against inflation. In broadly diversified portfolios, stocks do help mitigate against inflation. If you invest everything you have in stocks, you are probably fairly protected against inflation. However, most diversified portfolios have cash and fixed income securities. These are vulnerable to inflation.

Let’s look at some numbers. Whenever you are thinking about your percentage of return, think about inflation as well. For example, if your stock investments give you an average annual return of 10% and the annual average inflation is 3%, the actual return you have from your money is really 7%. Think of it this way — what you are making now will actually buy less in the future — so you may need a little more than you anticipate. That is why you should factor in inflation.

But if you have a 6% bond and inflation is 8%, you have a negative return on your money.

I’m not saying don’t invest — but if you are nearing or already in retirement, inflation is something you should take seriously. While many people assume that all of your portfolio should be switched to fixed income securities, that might not be the right way to mitigate inflationary pressures on your portfolio. Even in a low inflation environment, it is often wise to keep a portion of your portfolio in stocks to counteract the loss of purchasing power.

Remember, there are stocks out there that are pretty good bets. Large, existing companies that have excellent and solid histories are good options. Think your blue chips here.

Don’t go out and change your portfolio right away. If you don’t see a problem, keep doing what you are already doing. But keep an eye on your portfolio. When planning your investment goals, keep inflation in mind. Keep an eye on your fixed-income securities. Plan ahead.

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