How inflation eats purchasing power
Inflation is the phenomenon of the general price level rising over time. Mathematically, 2% annual inflation compounded for 30 years shrinks purchasing power by roughly 45%. In other words, even if your nominal balance stays flat, the goods and services it can buy will decline.
This matters for asset allocation because different asset categories respond to inflation differently.
How each category tends to behave during inflation
The characteristics below are commonly discussed in public literature. They are conceptual descriptions only — historical behavior does not guarantee future results.
Cash and short-term deposits
The most direct victim of inflation. If demand-deposit or time-deposit rates sit below the inflation rate, real purchasing power declines every year. The upside of this category is very low principal volatility and high liquidity, but it offers no inflation hedge.
Bonds
When inflation rises, markets generally expect central banks to hike rates to rein it in. Higher rates pull down the market prices of existing lower-coupon bonds. Long-duration bonds are more sensitive to rate changes than short-duration bonds.
There are also "inflation-protected bonds" (TIPS / inflation-linked treasuries), whose principal or coupon adjusts with an inflation index — a category explicitly designed around inflation.
Stocks
The relationship between stocks and inflation is more complex. Corporate earnings do reflect rising prices over the long run, but in the short term, rate hikes can compress valuations. When inflation runs hot or spikes suddenly, stocks and bonds can fall together.
Real-estate-linked assets (REITs)
Rents and real-estate values generally adjust with inflation. But REITs are also sensitive to the rate environment, so they are not a pure inflation hedge.
Commonly discussed directions
Directions frequently raised in public literature:
- Keep a meaningful stock allocation: for long-run resistance to purchasing-power dilution
- Cap long-duration bond exposure: avoid concentration in highly rate-sensitive positions
- Consider adding real-estate-linked categories: as a diversification supplement
- Review the cash position regularly: avoid holding more cash than you actually need, to limit long-run inflation erosion
These are common directions in the discussion, not optimal allocations. Specific percentages still depend on your cash flow, horizon, tax situation, and risk tolerance.
The tool's perspective
The calculator on this site uses age as its main variable to compute category ratios and does not dynamically adjust for inflation. If you want to factor inflation into your allocation, you can adjust the tool's output ratios based on your own judgment.