Inflation is often referred to as a “hidden killer” by economists and investment professionals. It is not as obvious as market volatility or economic instability, but how inflation affects your investment portfolio over time can be just as devastating.
Said Ronald Reagan regarding inflation: “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman”.
Seems pretty extreme for something that isn’t a “real” thing, doesn’t it? Once you understand how detrimental inflation can be, you’ll soon realize that Reagan was not overstating inflation’s negative effects.
Furthermore, whether you understand how it works or not, inflation is a very real phenomenon. Failing to plan around it can jeopardize an entire financial plan.
This article will provide you with an introduction to what inflation is, how it works, and what you can do to minimize how it affects your investments.
What Is Inflation?
Inflation is defined as the gradual loss in purchasing power that is offered by a currency.
In simpler terms, it means that you need to spend more of the same currency to afford the same level of lifestyle over time. The less the currency is worth in relative terms to the goods or services it can provide a consumer, the less purchasing power that currency has.
Inflation happens for a number of reasons, such as:
- Central Bank Policy
- Shocks in the supply & demand of consumer goods
- Dramatic uptrends in production costs
- Sharp increases in wages
There are a lot of different economic theories on inflation, but they all agree on one thing: inflation is very real.
Unless we see a total overhaul in how money works globally, it will continue to be a force that you should understand and plan around as a long term investor.
Inflation varies by economy. In the United States, inflation has historically averaged around 2%. In other economies, like Venezuela, the overall inflation rate has reached levels as high as 344,509.50% according to TradingEconomics.
How Is Inflation Measured?
Domestically, there are two indices that are commonly used as benchmarks for tracking inflation. These indices are:
- The Consumer Price Index (CPI)
- The Core Price Expenditures Index (PCE)
CPI tracks the price of a weighted-average of a household’s “basket of goods and services”. In other words, this index attempts to track the cost of a typical household’s living expenses. CPI is often monitored for Cost of Living Adjustments (COLA) made to Social Security benefits, pension benefits, etc.
PCE is very similar to CPI, except it encompasses a broader range of spending instead of just a household’s staples. The Federal Reserve often references PCE over CPI in its meeting minutes.
The markets tend to pay close attention to releases of this data. It is not uncommon to see equity markets react sharply to shocks in the data.
Inflation and Monetary Policy
Inflation and monetary policy tend to be directly related (ironic, since both can affect your investments). When a central bank believes that an economy is under threat of forming a bubble due to excesses in inflation, it will usually deploy a type of “contractionary” monetary policy.
This is exactly what the Fed does when it hikes interest rates.
The thought process is that higher interest rates will disincentivize lending, thus slowing down the flow of credit within an economy. The slowdown of credit flow tends to slow down transactions. The slowdown in transactions tends to cause a “correction” in consumer pricing, which then helps mitigate inflation.
In fact, the Federal Reserve has actually pushed the economy into recessions in the past in order to avoid a bubble scenario. (Worried about how to prepare your portfolio for the next recession? The current one? We’ve got you covered!)
In the reverse, if a Central Bank wants to stimulate economic growth, it can cut rates. This in turn incentivizes lending, which creates more transactions across the economy. This naturally leads to some inflation.
Compounding Inflation; Or, How Inflation Affects Your Portfolio
While the term “compounding” tends to be synonymous with investment growth, many investors fail to realize that inflation has a compounding effect as well, which can then affect their investment portfolios. However, the key difference is that it’s negative.
Time is an important variable when it comes to inflation, just like with normal compound interest. Over time, inflation eats away at purchasing power more and more. This is the danger of sitting in cash or cash equivalents (such as money market securities) for extended periods of time. Each year, the cash is worth less in terms of relative purchasing power, regardless of whether the principal is preserved or not.
In the case of portfolio income planning, it is crucial to account for how inflation affects your investments over extended periods of time. $50,000 of portfolio income in one year will not afford you the same level of lifestyle or goods in 10 years, and so on.
How to Hedge Against Inflation in Your Investments
The best way to hedge the negative compounding effect of inflation is to:
- Get ahead of the curve
- Accumulate appreciating assets
As discussed, time is an important variable not only as it relates to inflation, but investing as well. In fact, one could argue that time is the most important variable in the investing equation. If you’ve heard of the term “time in the market vs. timing the market”, that is what is being referred to. The earlier you can start benefiting from the benefits of “positive” compound interest, the better.
The accumulation of assets that have the potential to appreciate in value is just as important. There are several asset classes that fit this description, including:
These asset classes tend to have return profiles that help an investor keep up with, and outpace inflation over time.
The general rule of thumb is: the more time you have on your side, the more aggressive you can afford to be. This is why it is more suitable for a 30 year old investor to have a portfolio comprised of 90% stocks compared to a retiree.
Investors that are highly conservative with their asset allocation tend to be prime candidates for inflation risk. The major trade-off with owning “safer” assets is the opportunity cost of forgoing precious capital appreciation. That results in inflation risk.
Unless you have the luxury of being able to withstand losing 2% (on average) of your portfolio’s purchasing power, you need to have some exposure to asset classes that will provide a hedge against inflation risk.
Planning Around Inflation in Your Portfolio
Unfortunately, there is not a whole lot that you can do when it comes to inflation on a macroeconomic scale. In fact, there is nothing you can do to control it.
What you CAN do is plan around it. A great financial planner will always incorporate inflation in their planning to make sure their client is able to meet their cash flow goals for decades, without having to worry about them sacrificing lifestyle, or worse, running out of money.
Even if you are not using an advisor, you can still plan around the affects of inflation on your investments using a handful of tools that are available to you.
Inflation calculators are helpful for providing you with context as to what your financial goals will cost in “future” dollars. Seeing that figure may provide you with a sense of urgency and make your goals seem more “real”. You can back into an appropriate level of contributions into your respective accounts and compare different assumed rates of return to get an idea of what it will take for you to meet that future goal. There are also more advanced software programs that incorporate inflation in cash flow analyses to provide you with even more accurate forecasts and projections.
Whatever tools you go with, make sure you understand the inputs and assumptions that go into the modeling.
If your situation is complex enough, it may be worth consulting with a professional to make sure you are putting together a thorough, comprehensive plan.
A Final Word on Inflation in Your Portfolio
Perhaps Reagan’s statement on inflation doesn’t seem so extreme after considering how it can affect your long-term investment goals. While you cannot control inflation, you can definitely educate yourself on it and plan around it.
The best defense against inflation is accumulating assets that keep up with it, if not outpace it, in terms of appreciation in value.
For instance, equities have been considered one of the best hedges against inflation for decades now. Alternative asset classes like Real Estate and commodities can also play a similar role in your portfolio. Leveraging time can also help you start getting ahead of the “inflation curve”.
If you’re sitting on a sizable portfolio and you believe that you have enough assets accumulated to provide you with decades of income, make sure that you account for inflation in your cash flow planning. Your “target” lifestyle this year will be more expensive next year, and the year after that, and the decade after that.
As long as we continue to operate under the current monetary system globally, we will continue to see inflation play a material role in economies. Understand how inflation works. Plan around it. Get ahead of it.
Have questions on inflation? Let us know!