By Massi DeSantis
You may have noticed that it costs almost twice as much to fill up your car at the pump compared to last year, or that the package of rib eye steaks you get every week is getting expensive. . On average, according to the Bureau of Labor Statistics (or BLS), the cost of living has increased at a rate greater than 5% over the past 12 months. This unusually high figure (an average inflation of around 2% per year over the past 20 years) has grabbed the headlines and you may be wondering what this means for your retirement plan and future returns of your investments.
Before panicking about inflation and making drastic changes, however, it helps to understand how inflation works and how it can impact your investment plan. Here is a brief overview of inflation and how you can plan for it.
What is Inflation?
Inflation is a general increase in prices and the cost of living. Over a period of time, the prices of some goods we consume increase (think a gallon of milk or a box of cereal) while others may decrease (the price of televisions). Inflation measures the medium price increase. If prices increase on average, it becomes more expensive to buy the same goods and services as before the price increase, so the cost of living increases. The Bureau of Labor Statistics publishes the most common measure of prices, called the Consumer Price Index or CPI.
When prices rise, the cost of living rises and so does the CPI. The CPI uses more than 200 categories of goods and services divided into eight major categories and collects the prices of these goods monthly in 75 different metropolitan areas. The BLS then constructs the CPI by weighting the prices of each of the goods and services by the amount that a typical household spends on each of them. For example, the typical household in the BLS sample spends 15% on transportation, so the transportation category gets a weight of 15%. Below is the breakdown of the latest CPI basket.
Over the past 12 months, the main sources of inflation have been energy costs, including gasoline and utilities, and transportation, including used car prices. More recently, you may have noticed higher prices in grocery stores and restaurants. There may be differences between states and regions of the United States, resulting in different baskets and different changes in the cost of living. The BLS website provides CPI information at the regional level.
Why is inflation bad?
The most obvious effect of inflation is that it decreases the purchasing power of your income, or real income. For example, if you got a 3% raise at the start of 2021 and the cost of living goes up 5% this year, your real income goes down about 2% this year. Although income tends to adjust somewhat to inflation over time, not everyone’s income will move in line with inflation, so high inflation can mean a decrease in your income. real, which can be particularly harmful for a pensioner living on fixed incomes.
Another cost of inflation is that it increases effective tax rates. Increases in income caused by inflation can put you in higher tax brackets while your actual income remains the same. Inflation also increases the taxation of your investments. Suppose your return is 5% when inflation is also 5%. Your actual return is nil because you earned just enough to cover the rising cost of living. However, you are taxed on the full 5% return.
There are also more general costs related to inflation. In times of high and unpredictable inflation, economic growth and stock market returns tend to be weaker. In the decade between January 1970 and December 1979, inflation averaged 7.4% a year, while the S&P 500 index averaged 5.9%, below inflation and below to its long-term average of more than 10%.
Periods of inflation have certain positive aspects. If you have a fixed rate mortgage, your monthly payments relative to your (inflated) income will be lower. And in many cases, at least if inflation is temporary, you can significantly reduce its negative impact by changing your spending habits, as we’ll see below.
Government policy and inflation
Government policy, whether monetary or fiscal, tends to be inflationary. The increase in government spending financed by the purchase of government bonds by the Federal Reserve (“the Fed”) is inflationary. The Fed’s purchases of existing government bonds to increase the money supply can also be inflationary, especially if the Fed insists on maximizing jobs. If inflation gets out of control, historical experience shows that the cure can take a long time and lead to slower growth and higher unemployment for some time, as we saw in the 1970s and early of the 1980s.
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What can you do?
You might be tempted to follow the news and various pundits trying to predict inflation and pick investments that might do well if inflation rises. However, historical experience shows that, unfortunately, we cannot predict the future of inflation with any reliability. We can only believe that the Fed will use its tools to control inflation, and not necessarily that they will succeed. Likewise, don’t rush to buy gold or other commodities to protect your nest egg against inflation. Research shows that gold is not a good “hedge” against inflation for most investment horizons. Current prices also show that gold is expensive relative to the CPI, based on historical evidence (current gold to CPI ratio is 6.5 vs historical 3, 5). So what can you do? Here are some suggestions that are not based on predicting the future.
Make a plan
If you’re worried about inflation, make sure you have a good financial plan in place to achieve your goals. Whether you’re planning for future retirement, assessing your retirement readiness, or estimating how much you can safely withdraw from your nest egg, a financial plan that takes into account multiple inflation scenarios via a Monte Carlo simulation is a good way to prepare for inflation risks. . Historically, we have had periods of high inflation and low inflation, high interest rates and low interest rates, etc. Your plan should be robust to a range of scenarios.
Stick to the planning process
Making a plan is the first step, but planning is a process. Be sure to revise your assumptions and plan as your financial situation changes. Currently, you may want to pay more attention to your spending with rising inflation, as we suggest below. But inflation fears can be temporary. The economy may get back on track and you may get a bigger raise than expected, or your returns on investment may be better than expected. You should create some flexibility in your plan and review it often, once or twice a year.
Set a budget and track your expenses
A budget sheds light on your spending habits and can help you find opportunities to save. Check out this article to create your first budget or this one to help you track your expenses. Here are some ways to cut spending in times of high inflation. First, keep your durable goods longer. Wait to buy your next car if you can, to avoid temporary price pressure. Buy used. You probably don’t need a new SLR camera or a mountain bike if you’re just trying out a new hobby. The local Facebook market is a great place to shop.
Reduce your driving and save on gas, which has increased by more than 30% in some parts of the country. Take a hike and check out what your neighborhood has to offer. If you need to fill up, according to gasbuddy.com, a website to help you save on gas, Monday and Tuesday are days when gas prices are historically cheaper. Finally, if you love to travel, explore cheaper destinations to save on travel and explore places closer to home.
Refinance your debt
If you haven’t yet taken advantage of historically low interest rates, you may want to consider refinancing your mortgage or other loans. Low interest rates mean that the price of borrowing is particularly low. Lowering your loan costs means you have more money to meet other costs that may rise.
Review your portfolio
I put this one last because a good portfolio allocation should always take into account the effects of inflation, regardless of the headlines. A retirement portfolio should have some exposure to Treasury Inflation Protected Bonds, or TIPS. Unlike gold or other commodities, TIPS are a good hedging instrument because bond payments are adjusted based on the actual CPI. Although limited to smaller amounts, I Savings Bonds are also a good inflation instrument to consider and can give you higher returns than TIPS.
Finally, long-term investing benefits from exposure to equities. Historically, stocks have outperformed inflation and commodities like gold over the past 50 years. How much stocks versus bonds should depend on your goals and time horizon, not so much on current inflation fears, so start there.
You get the point. The bottom line is that there is no magic bullet against unexpected inflation. This is simply one of the risks that investors need to take into account when developing their investment strategy. If you don’t have a strategy or would like to revise yours, start by reviewing our discussion of the risk-return trade-offs of investing and how to develop your own investment guidelines.
About the Author: Massi De Santis
Massi De Santis is a paid financial planner from Austin, TX and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their assets throughout their lifetime. As a fee-based, fiduciary and independent financial advisor, Massi De Santis never receives a commission of any kind and has a legal obligation to provide unbiased and trustworthy financial advice.