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What is Inflation, Consumer Price Index, and what does it mean to your portfolio-investments?

Another article I self-published in 2010. Although some examples and the individuals I mention are irrelevant today, the article's content is very factual! Please read and enjoy:

First I want to define these topics and in the end give you my personal opinion on what will happen (and why) in the near term:

Inflation: The rise of prices of goods and services in an economy over a period of time. In other words, think of any merchandise you purchase (iPod, books, camera, movie tickets) and places or people you pay such as a mechanic, an attorney, an accountant, and/or a Doctor. In time the prices always go up. Now when this happens, the currency (US Dollar, Euro, Peso, etc.) buys fewer of these goods which in short LOWERS your purchasing power (The ability to buy...anything). This is a loss of real value, which happens over time. To make this even simpler, for those that have been around in the 80's and earlier, what can a dollar used to buy you? There was a time when the ".99 cents" store sold things that were actually .99 cents. Now it is not the case.

This is part of the economic cycle. Yes, we have to go through a cycle in order for economics to perform correctly (in order not to side track, we will remain on this topic). Inflation is not positive or negative for the economy, it's both. Negative that your purchasing power goes down, which in turn makes people more reluctant to purchase goods, investments, and savings. In turn, it is positive in which the economy can recover from a recession and debt relief by reducing the level of debt. There is also Hyperinflation but I will speak of this later in the blog.

Now, after reading this, you should be thinking of the recent events and reports (if you know them) regarding how the national debt has been recently reduced and savings have gone up (more people are paying off debt and saving money). This is signs of beginning inflation. But what else are signs of inflation? Consumer Price Index that's what!

Consumer Price Index (CPI): Also known as the "True Cost of Living Index". This is simply a measurement of the average consumer (buyer) goods and services by household. Usually the goods are based on urban products that most households will need/want. Without getting too technical, it is also measured in weight (as in kilograms, LBS, etc). So weight+price=CPI. Now some countries report the CPI annually while some quarterly. As I mentioned before, the other name pretty much speaks for itself (True Cost of Living Index), in which CPI measures the rise and fall of cost of living. Why? CPI not only helps measure inflation but also wages, salaries, and pensions. In a nutshell, this index lets you know how much INCREASE you need to have PER YEAR in order to maintain the lifestyle you are currently living. For example: If CPI rose 2.4% for 2009, if you do not have an annual increase of that amount, you will (in a couple of years) not be able to maintain your current lifestyle because that dollar/peso/euro will not be able to buy you that same product that you normally purchase (because that price WILL go up eventually and yet you make the same leaving you with less money). *To see the numbers for yourself, I have included a link (located at the bottom of this article) from the Department of Labor that has a simple calculator.*

So this is a very important index! But how important is it to YOUR portfolio? If you only measure your investments and portfolio on the current stock market such as the Dow Jones, S&P, and/or Nasdaq, you are doing it wrong. As we have seen from the recent crash last year (Fall of 2008) the market drop to levels that set your portfolio back nearly, if not, 10 years (or more, depending on how NOT diversified you were) however CPI was at ZERO of 2008. So if you made 1% return AFTER TAXES then you did EXCELLENT for 2008. Please note that I said "after taxes" because a CD @ 2% for +12 months after taxes long term will not beat CPI, I will explain this on another blog in the near future. If you interview an adviser who wants to manage your money and says he measures your portfolio based on the markets and fails to mention CPI and YOUR expectations, run away!

What may happen in the near term (prediction for the USA): With talks of health reform, what we have already spent on companies not to fail, the stimulus packages, tax cuts that happened during the years of Bush, unemployment extensions, and everything else in between (such as the cash for clunkers), we have no choice but to make cuts and raise/add taxes. For example, congress may pass a law to tax EACH trader's transaction. Now I won't comment on this however you understand the idea. Tax increases will occur (but stated "in the future" which means it WILL happen). In addition, the City of New York's Governor Paterson is planning on raising taxes on film/television/theaters performed here in the great city of New York. At the same time, he has cut education and health care funding. I mention NYC because NYC is supposed to be one of the major benchmark cities in the United States, so if they are doing it, most likely your city might do the same (with the exception of a few smaller cities)!

This leads to what I believe will be a "Hyperinflation". This is, as the words "hyper" means, an out of control inflation which everything I have mentioned above but with extreme higher numbers of price increases and massive drop on currency value. In addition, history of "hyperinflation" is usually caused by the following: Aftermath of wars (We are withdrawing from Iraq by end of 2011), economic depressions (The major recession we are currently in that I feel will end by the end of 2009 or early 2010 THE LATEST), and political/social upheavals (Healthcare reform? Changes in Wall Street?).

The ONLY way to avoid this hyperinflation is if Bernanke (Chairman of the Board of Governors of the United States Federal Reserve), Geithner (US Secretary of the Treasury), and the President do not take pressure from the outside community and SLOWLY raise rates and taxes because face it, with the rates and taxes at these levels, we enjoyed are tax cuts and lowered credit card rates but it was bound to come to an end.

What to do with your money during inflation? Invest in HARD consumer products. What do I mean by "hard"? Products and goods that you can actually touch, that the price will rise such as precious metals (my favorite). Gold does exceptionally well when the dollar decreases. Now you know that inflation, value of the currency goes down, so precious metals like Gold will rise. Not to mention the prices on products that use gold, silver, bronze, etc. will rise due to inflation. So that's where I would put my money. Other places would be in is Blue-Chip stocks that pay a dividend (stock price may go up or stay the same but you receive an income from that dividend). Equities may very well outperform during the upcoming inflation (saving rates will stay the same but most likely drop due to many non-educated investors just putting everything in CD's and savings). But there is something for you non-equity traders/investors: TIPS (Treasury Inflation Protection Securities) which pays you a decent yield but also the price of the bond adjusts with inflation making sure you do not go under that CPI keeping you at par. Not to forget, it is backed by the full faith and credit (and taxing power) of the United States. Plus TIPS are exempt from Federal taxes (growth & income) but subject to state and local. Not a bad deal!

So instead of worrying about inflation, just prepare for it (what we in the industry call a "Hedging"). Best case scenario is we just have a regular inflation and I was overestimating...but isn't it better to be safe than sorry?

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