Here’s how inflation can undermine a financial plan. Let’s say that at the end of the year you had $1,200 under your mattress. But if, during the course of that year, inflation rose 4 percent, that $1,200 in cash can now buy you only $1,152 of goods and services compared to what it would have bought a year ago. You actually lost purchasing power! If, instead, you had parked that $1,200 in a money market mutual fund with a return of 4 percent annually, your $1,200 would have earned $48, exactly the amount by which inflation grew. So you are still able to buy the same things without eating deeper into your portfolio. In other words, you broke even. That doesn’t sound good, I know, but breaking even is a lot better than losing money.
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