Inflation has come to be an expected part of the U.S. economy. However, we must also consider the possibility that one day the economy might deflate considerably, bringing the value of an investment down rather than up.
As an investor, everyone is interested in the effects of inflation upon his investment program, because he is interested in the preservation of the principal amount as expressed in dollars, which he originally invested, and in the income received, which is also expressed in dollars.
In neither case is there any particular label put upon the dollars themselves. Only the nature of the times (the "price level") tells whether the dollars are inflated or not. Obviously, the investor will be seriously concerned if his investments yield him a return in dollars which have lost their purchasing power by 50 percent; not only that, he may have made a long-term investment (such as bonds) and when the invested capital is returned to him, he finds, much to his dismay, that it is in dollars that are not the same as those which he originally invested. Let us now show how this works out by a few examples, wherein we may find a clue to a means of minimizing the impact of inflation.
Suppose that in 1940 an investor bought a $1000 bond bearing 3 percent interest. During the years that followed he would receive $30 each year as income from his investment for the period of the bond itself, say 26 years; at the expiration of that time, he would receive his original capital back again. There would be two things that would be difficult, if not impossible, to foresee: whether the dollars received as income would all be of the same value throughout, and whether the final return of principal would also be in money of the identical purchasing power which it had at the beginning. The same is true of all other fixed-dollar investments. Life-insurance dollars, when paid upon the death of the insured, may or may not buy as much as the dollars originally invested in the contract. Even money put away in a savings bank is not exempt from the ravages of inflation.
In the last decade elderly folk have been rudely awakened to the realization that their retirement income, of a fixed number of dollars, has proved insufficient and that they must make many personal sacrifices in order to get along; in some instances, where state or other government aid is provided, some effort has been made to soften the blow by providing modest increases in pension funds. Another case might be that of a widow whose husband left her "well provided," only to find throughout the years that as a result of the gradual erosion in the purchasing power of the dollar the amount of her financial protection had actually decreased with the passage of time.
Inflation and deflation are facts of the economy, and investors who wish to see the value of their money increase rather than decrease absolutely must understand these principles.