Small things can hurt you -- germs, termites and inflation. If you lived the early '70s, you're well aware of the hazard of big inflation. With 10 percent inflation, something that cost a dollar one year would cost $1.10 the next, and $1.21 the year after ... and twice as much after seven years.
It's not so obvious that relatively low inflation is damaging, but it is, too.
That's why a recent government report that the producer price index had risen 1.7 percent in October was so alarming. Stock and bond prices dropped on the news.
Hopefully, the figures represent a short-term blip rather than a long-term trend. Energy prices, while still high, have come down a tad since October. Food prices also may drift lower, following the spike caused by the recent hurricane damage to crops in Florida.
But inflation is worthy of every investor's attention because of its corrosive effect on returns over the long run. The Federal Reserve is concerned enough about the potential for rising inflation that it has raised short-term interest rates four times since June.
By raising borrowing costs, the Fed hopes to cut back on spending by individuals and companies. That means lower demand, making it harder for producers to raise prices and for workers to demand raises.
Toll on portfolios
Inflation also affects investors. To see inflation's effect, consider a portfolio worth $100,000 today, invested in a mix of stock and bond funds that will produce an average annual return of 8 percent. After 20 years, the portfolio would grow to $466,000.
But if inflation averages 3 percent a year, the "real" -- after-inflation -- return, would be 5 percent, and the real value would be just $258,000. In other words, the portfolio would buy what $258,000 buys today.
Now suppose inflation rises to a 4 percent annual average. The portfolio would average a real return of just 4 percent. In 20 years, it would still grow to $466,000, but the higher inflation would leave that with the buying power that $213,000 has today. So the mere 1 percentage point rise in inflation would do serious damage to the portfolio.
Over long periods, inflation has averaged 3 to 4 percent a year, and those are the figures financial planners typically use when preparing long-term financial plans. But the inflation figure -- from the government's consumer price index -- is based on price surveys of thousands of items. No single person buys all of them.
If you expect in the future to spend a lot on fuel, medical care or college tuition, your own inflation rate may be quite a bit higher than the broad average.
Investment insight
A long-term investor should build in a cushion, and it's important to know how inflation affects various types of investments.
It's easy to see how inflation undermines the value of bonds. The fixed payment you receive each year for the life of the bond will have less buying power as inflation makes every dollar worth less.
Because of this, a bond with a low interest rate, or yield, is less appealing as inflation rises. You could pay $1,000 for a bond, only to find a few years later that no one would give you more than $800 or $900 if you wanted to sell it before maturity.
Inflation's effect on stocks is trickier to predict. Higher costs for raw materials and labor undercut corporate earnings, which is obviously for share prices.
And since inflation cuts the purchasing power of the dollar, the same amount of earnings is worth less if inflation takes a bigger toll. More bad news for stocks.
On the other hand, companies can raise prices during periods of inflation, perhaps increasing profits enough to offset those other factors. Also, the value of a company's assets -- factories, office buildings, truck fleets and so forth -- rises along with inflation, helping to neutralize inflation's damage.
Of the three major investment types -- stocks, bonds and cash -- there's no question that over the long run stocks do the best job of offsetting inflation.
Since the end of World War II, stocks have produced average returns, after deducting for inflation, of about 7 percent a year. Bond returns averaged less than 1 percent, after inflation. Cash, such as bank savings, money-market funds, actually lost value once inflation was taken into account.
Many experts doubt stocks will do as well during the next 10 or 20 years as they did during the previous 60. Yet most believe stocks will continue to beat bonds and cash.
The best way to counter inflation is simple but not painless: Cut your living expenses and save and invest more.
At a minimum, the sum you put aside for long-term needs such as retirement and college should be increased each year by a percentage equal to the inflation rate.
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