Understanding Inflation and how Deal with it
Table of Contents
What Is Inflation?
Inflation is the rate at which a currency loses its purchasing power as prices increase over time. So, say a cup of coffee cost $1.00 twenty years ago. If the average annual inflation rate had been 2% between then and now, that same pour would now cost you $1.49. Various goods, services, and sectors often experience different rates of inflation at different times, but in general inflation is usually calculated based on the Consumer Price Index (CPI), or a similar broad pricing index.
Not all inflation is bad
In fact, a bit of inflation goes hand in hand with economic growth and reasonable interest rates for lenders and borrowers alike. A 2% annual inflation rate is typically considered a desirable norm for greasing the wheels of commerce, without destroying the working relationship between currencies and costs.
What if Inflation Runs Amok?
And yet, while inflation has its purposes, it’s concerning if it goes on a rampage. When it does, uncertainty has spiked as well, wreaking havoc on commerce, the economy, job markets, real estate, and financial markets. (Deflation—the opposite of inflation—can also upset the economy if prices drop too precipitously.)
Investors who were around in the 1970s may remember the last time the U.S. experienced red-hot inflation, and what it felt like when it spiked to a feverish 14.8% in 1980.
The New York Times described it as an era when “prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 percent, and interest rates on bank certificates of deposit approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.” While 12% CD rates may sound great, when interest and inflation rates are comparable, the real returns from even high-interest CDs essentially become a wash.
After the 1980 high-water mark, the Volcker-era Federal Reserve tamped inflation back down. So younger investors have heard of, but never experienced such steep inflation for such an extended time. Despite occasional alarm bells, inflation has mostly continued to hit the snooze button for decades.
What Can You Do About It?
We know the future remains uncharted. As always, with nearly any outcome being possible, and none being inevitable, this means diversified investing remains our preferred strategy for being prepared for whatever the future holds.
Because We Don’t Know, We Diversify
It stands to reason: Some investments seem to shine when inflation is on the rise. Others deliver their best results at other times. Because we never know exactly when inflation might rise or fall, we believe an investor’s best course is to diversify into and across various investments that tend to respond differently under different economic conditions.
For example, until recently, value stocks had been underperforming growth stocks for quite a while. You may have been tempted to give up on them during their decade-plus lull (during which inflation remained relatively low). And yet, when inflation is high or rising, value stocks tend to outperform growth stocks.
Another example is Treasury Inflation-Protected Securities (TIPS) versus “regular” Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across various inflationary rates.
In short, if you’ve not yet done so, it’s time to define your financial goals, and build your personalized, globally diversified portfolio to complement them.
If you’ve already completed these steps, you should be positioned as best you can to manage higher inflation over time, which means your best next step is most likely to stay put. This brings us to our next point …
Stocks vs. Inflation: It’s a Knock-Out
Provided time is on your side, the stock market is your greatest ally against inflation.
Over time, global stock market returns have dramatically outpaced inflation. For example, as reported by Dimensional Fund Advisors, $1 invested in the S&P 500 Index from 1926–2017 would have grown to $533 worth of purchasing power by the end of 2017, after adjusting for inflation. Had that same dollar been held in “safe” one-month Treasury bills over the same period, it would have grown to an inflation-adjusted $1.51.
That T-bill growth is not nothing, and welcome relief during bear markets. That’s one reason we advocate for maintaining an appropriate mix between wealth-accumulating and wealth-preserving investments. But what’s “appropriate”? It depends on your personal financial goals. The point is, as long as you have enough time to let your stock allocations ride through the downturns, you can expect them to remain well ahead of inflation simply by being in the market.
It’s important to add, no fancy market-timing moves are required or desired when participating in the stock market. In fact, moving holdings in and out at seemingly opportune times is more likely to detract from the vital, inflation-busting role stocks play in your portfolio. In the words of Nobel Laureate Eugene Fama: “The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.”
What If You’re Retired?
So far, so good. But not all your wealth is for spending in the far-off future. What if you’re depending on your portfolio to provide a reliable income stream here and now? If you’re retired, (or you have other upcoming spending needs such as college costs), eventual expected returns offer little comfort when current inflation is eating into today’s spending needs.
Again, you can’t control inflation, but you can manage your own best interests in the face of it.
Engage in Retirement Planning: Along with a globally diversified investment portfolio, you’ll want a solid strategy for investing for, and spending in retirement. For example:
- Asset Location: Among your taxable and tax-favored accounts, where will you locate your stocks, bonds, and other assets for tax-efficiently accumulating and spending your wealth?
- Spending: How much can you safely withdraw from your investment portfolio to supplement your other income sources (such as Social Security)?
- Withdrawal Strategies: Which accounts will you tap first, and then next?
Revisit Your Retirement Planning: Especially when inflation is on the rise, it’s worth revisiting your existing investment and withdrawal strategies. What are the odds your current portfolio won’t deliver as hoped for? We typically use odds-based “Monte Carlo” simulations to ask this critical question, and guide any sensible adjustments the answers may warrant.
Don’t Panic: What if inflation is taking too big a bite? A common misstep is to abandon your carefully structured investments in pursuit of short-cuts. For example, it may be tempting to unload high-quality bonds and pile into gold, dividend stocks, or other ways to seek spendable income. Unfortunately, we believe such substitutes detract from effective retirement planning. The goal is to optimize expected returns and manage unnecessary risks in pursuit of a dependable outcome. As such, we suggest avoiding dubious detours along the way.
Have a “Plan B”: What can you do instead? In “Your Complete Guide to a Successful and Secure Retirement,” authors Larry Swedroe and Kevin Grogan describe how to prepare an upfront “Plan B.” If a worst-case scenario is realized, you’re then better positioned to make any difficult decisions required to recover your footing. The authors explain:
“Plan B should list the actions to be taken if financial assets drop below a predetermined level. Those actions might include remaining in, or returning to, the workforce, reducing current spending, reducing the financial goal, and selling a home and/or moving to a location with a lower cost of living.”
These sorts of belt-tightening choices are never fun. But you should prefer them over chasing unsubstantiated sources of return that could dig your risk hole even deeper.
How Can We Help?
While anyone can embrace the strategies we just described, implementing them can be easier said than done. Plus, there are more steps you can take to defend against inflation, near and far. Examples include engaging in additional tax-planning, annuitizing a portion of your wealth, tapping lines of credit like a second mortgage, optimizing Social Security benefits, and more.
We hope you’ll contact us today to discuss these and other retirement planning actions worth exploring. After all, making the most of your possibilities is always a smart move, whether or not inflation is here to stay.
Ted Fischer is a Fee-Only Certified Financial Planner® & fiduciary, and the founder of Fischer Investment Strategies.
Drawing from more than 25 years of experience in the financial services industry, Ted's expertise includes retirement planning, investment analysis, tax planning, estate planning, and insurance.
Ted has an extensive academic background. He received his Certified Financial Planning (CFP®) designation from UCLA in 2011. He became a Qualified Plan Financial Consultant (QPFC®) and an Accredited Investment Fiduciary (AIF®). Ted has a Bachelor of Science in Marketing, with a minor in Finance, from San Diego State University.