Why invest one's money? A common answer would be "to make more money", yet a successful investor can only start making money once they have stopped an hemorrhage that's easy to forget, inflation. Present in most countries, it is the phenomenon by which money loses purchasing power over time.

If I think of investing, the bare minimum that I would like to accomplish is just that: preserving the purchasing power of my savings. I won't be particularly happy if that's all I manage to do, but on the path to finding a decent investment strategy, compensating for inflation is my first step.

Let's look at how successful an investor has to be in order to accomplish just this. Their return on investment would have to at least match inflation. So how much is inflation? According to the US inflation calculator, the rates for the past years in the United States were:

2013: 1.5%
2012: 1.7%
2011: 3.0%
2010: 1.5%
2009: 2.7%

Let's assume, to keep things simple, that inflation is 2% a year on average. Let's also consider an investor who has $100,000 worth of savings in a bank account without interest. Based on our 2% inflation rate, in five years, the purchasing power of those savings will have become equivalent to what $90,392.08 can buy today. About one tenth of the purchasing power will have been lost. In order to retain the same purchasing power, our investor would need to find a way to grow those savings into $110,408 in five years. This amount will be able to buy then what $100,000 can buy today.

Let's see how one might manage to grow savings at a rate of 2% a year. My bank accounts are at Chase so I looked up their interest rates to see how well they help me at the task of keeping up with inflation. Put simply, checking accounts yield 0.01% interest. That will bring the $100,000 up to $100,050 after five years. At 0.1%, savings accounts can bring 10 times more, leaving a balance of $100,501 after five years. This is still quite far from the 2% which would bring our investor to the $110,408 which is needed to match inflation.

Some banks offer high interest savings accounts. According to this survey, some banks go as high as 0.95% interest rate. That's enough to cut in half the inflation, but not enough to stop it, much less to make profits.

Banks also offer certificates of deposit, instruments which deliver a fixed interest rate if money ix locked into them for a given amount of time. The more money is deposited and the longer the period, the higher the interest rate. Based on Chase's CD interest rates, a deposit of $100,000, if locked in to a CD for 10 years (a better rate than the 0.6% one gets for five years), will yield 1.05% a year of interest. After five years, that brings the deposit up to $105,361. Still not enough to match inflation.

Let's hold on for a minute and talk about taxes. Interest that comes from bank accounts and CDs is taxed in the US similarly to salaries. Now let's say our investor is in the 25% federal tax bracket. That's pretty typical for upper middle class. Let's say they live in New York state and are in the 6.65% tax bracket. Let's just assume, to give this fictional investor a breather, that they do not live in New York City where they might get another 3.648% on top of that. Social Security tax which has a fixed rate of 6.2% and the Medicare tax of 1.45% don't apply to interest income.

This brings us to a total tax rate of approximately 32%. This is roughly how much extra income (salary or interest) gets taxed for someone who was in the brackets mentioned above. Back to the CD example, the $5361 of interest is actually only $3645 after those taxes. If we take taxes into account, it's not an interest of 2% that is needed to match inflation, it's actually 2.9%.

Does one even stand a chance at beating inflation? Let's look at other forms of investment. I checked what's available now in the secondary bond market, and there are offerings which match this with <5 years to maturity with a credit rating in the low A's and high B's. Those are considered investment grade by the Fidelity bond search tool which means they consider them pretty safe.

So bonds are one method that works. Let's now look at investing in stocks. Successful investing in stocks will yield capital gains when the stock is sold. Some stocks will also provide dividends. Both capital gains and dividends can be taxed at the terrible 32% rate. However, there are huge exceptions.

Most dividends from US corporations traded in the stock market are qualified dividends and because of this are taxed at 15% maximum (except for people in the $400,000+ tax bracket). Capital gain which results from the sale of investments held for more than a year is dubbed long-term and is subject the same tax as dividends. The 6.65% state income tax still applies to both however, for a total of about 22%. With that value, we're down to a required 2.6% of income as capital gains or qualified dividends in order to keep up with inflation.

Many stocks have dividends which exceed 2.6% a year. Also the major US indices tend to grow by more than 2.6% a year for long-term periods. It's possible to invest in ETFs whose price will track these indices and therefore have similar performance. Then again, nothing is guaranteed. A stock with a high dividend could drop in price. Or the market could start performing badly as a whole. But past performance has given investors a lot of opportunities to beat inflation in this way.

Another popular mode of investing is mutual funds. Brokers provide lots of details about their past results. Yet one challenging aspect of mutual funds is predicting their tax impact. Most funds, while held in an investor's portfolio, will generate distributions throughout the year. These can be for long- or short-term capital gains, or qualified or unqualified dividends. However, because mutual funds are opaque about their holdings, knowing in what proportions these will come and therefore what their tax rate will be is difficult. One can always assume the worse, in this case 32%.

Now's a great time to talk about retirement accounts. If the money being invested is in a retirement account like an IRA or a 401k (Roth or traditional), the income would not get taxed as it accrues, in which case it makes no difference what the taxes are. All that's needed is for the mutual fund to reach the 2% return to match inflation. All the other types of investments income will not generate taxes as they accrue either, so keeping up with inflation is easier in a retirement account.

In the course of this research, my goal was to figure out what an investor can do to merely match the inflation rate. Based on rough calculations, it looks like for interest-bearing instruments, the minimum rate of return would have to be 2.9%, while stocks would have to produce 2.6% at least, including capital gains and dividends. Among common investments, stocks, bonds and mutual funds seem to have the potential to offer returns high enough to match inflation.