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The Impact of Inflation - Pinnacle Investment Management, Inc.

The Impact of Inflation

May 17, 2016 / Blog

 

On October 8, 1974 President Gerald Ford addressed Congress and the American people and discussed what he considered one of the gravest threats to the country: inflation. In his speech he stated:


I say to you with all sincerity that our inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy.

 

In the 1970’s inflation averaged close to 7%, more than double the long term average. With inflation at 7% a year, $100,000 saved in 1970 would be worth about $50,000 by 1980. It was a decade that was not kind to savers or investors alike.

Famously, President Ford created his W.I.N campaign (Whip Inflation Now) to fight inflation, but it wasn’t until the early 1980’s that it was finally brought under control.

Today, things look a lot different. Since the 1980’s, inflation has remained relatively contained and, in recent years, has been very low. From 2010- 2015, the official US Consumer Price Index averaged 1.4%, well below the long term average of 3%. Yet while inflation isn’t grabbing front page headlines or running at rampant rates like it was in the 70’s, it is still a risk investors need to be aware of and account for in their financial and investing plans. There are two aspects to this risk. First, due to the powers of compounding, even inflation averaging just 2% a year can have a negative impact on your wealth over the long term. Second, the official inflation number that is reported may not represent your “personal inflation rate.” The areas where you spend your money may not line up with what makes up the Consumer Price Index. Robert Arnott and Lillian Wu with Research Affiliates recently wrote:


The price of beef has been soaring over the past five years — up 80% cumulatively at the end of December 2015—but you’d never know it by looking at the official U.S. Consumer Price Index, which is up 7% or 1.4% a year, over that five-year span, and therein lies our beef.

 

What is Inflation?

Inflation is defined as a general rise in the price of goods and services. As inflation rises, the amount of goods that your dollar will buy decreases. It underlines the idea that a dollar today is worth more than a dollar tomorrow.

As mentioned above, the long term average for inflation is 3%. To put that into perspective, if you put $100 under your mattress for a year, it would be “worth” $97 at the end of the year. While that may not seem substantial, over long periods of time a 3% inflation rate can eat away at the value of your money. Below is a chart from BlackRock showing the impact of inflation over longer stretches of time.
Blackrock Picture
Inflation is one of the reasons why prudently investing your money is so important. Keeping all your money “under the mattress” may feel safe, but it provides only a false sense of security.

 

The Risks of Inflation

One of the biggest risks of inflation is that it is an “unseen” phenomenon and thus it is relatively easy for investors to become complacent about it. There is a reason why many consider inflation the “silent killer” of your finances. Inflation doesn’t show up on your investment statements, yet it is compounding away in the background.

Another key aspect to understand with inflation is that it comes in many different shapes and sizes. The inflation rates that we mention above are purely averages based upon a basket of prices, and so each person will experience inflation differently depending on where they spend their money. The chart below shows the inflation rate for different components of the Consumer Price Index:

Inflation picture

As the chart demonstrates, medical care has had the highest inflation rate since 2000, and it isn’t expected to slow down any time soon. The Centers for Medicare & Medicaid Services Office of the Actuary project health care spending to rise by about 6% per year through 2024.

Since retirees tend to spend more of their total income on health related expenses, their personal inflation rate may be much higher than the official CPI. While social security is adjusted for inflation, the adjustment is based on CPI-W, which is a price index for Urban Wage Earners and Clerical Workers, and thus it may not fully reflect the real costs for a retiree. For instance, in 2010, 2011, and 2015 there was no Cost of Living Adjustment for Social Security. In contrast, the Medicare Part B premium increased 16% in 2016 for new enrollees!

One last risk to be aware of with inflation is that it can come up unexpectedly. While inflation has remained relatively subdued recently, history has shown that in a very short period of time it can increase dramatically. With seven plus years of aggressive monetary policy and continued easy money from most central banks, inflation may come to the forefront very quickly.

 

Ways To Combat Inflation

1. Understand Your Real Returns
Real returns are the returns you have after you account for inflation. Nominal returns are the returns before inflation and are what you see on your investment statements. So for instance, if you own a bond that pays you 3%, that 3% is considered the nominal return. If inflation is 2% during the time you hold the bond, then your real return is approximately 1% (3%-2%).

With regard to the stock market, since 1928, the S&P 500 has had a nominal return of about 9.6%, while the real return was around 6.5%.

Your real returns are what matters, even though you will only “see” your nominal returns.

 

2. Account for your Personal Inflation Rate
It is important to understand what your personal inflation rate is and what it may mean for your finances. Many retirees believe that once they reach retirement they should change their investment portfolio to be more conservative. While there is some truth to this assumption, it is also important for retirees to account for rising health care costs and how they will pay for them. The same holds true for parents that are saving for their children’s education.

 

3. Maintain a diversified portfolio
As previously mentioned, playing it safe with all of your savings isn’t actually safe. Over long periods of time one of the only ways to fight against the risk of inflation is to have a  diversified portfolio that includes stocks. This is especially true for retirees.

While fixed income investments do not fluctuate in value as much as stocks, it is important to keep in mind that while they provide fixed income, your costs are not fixed and will continue to rise.

In inflationary times, other assets, such as real estate, commodities and inflated linked bonds, have also shown to offer some benefits.
4. Find an asset allocation that you can stick with
Whenever there is market volatility, it is a common reaction to take your money out of the stock market and keep it in cash until things settle down. As we previously discussed in our post on loss aversion, investors tend to hurt their returns by not correctly understanding their risk tolerance. The best course of action for investors is to find an allocation that not only will help them achieve their financial goals, but also one that they can hold onto in both good times and bad times.

 

Sources & Further Reading

President Gerald R. Ford’s Address
Advisor Perspectives: What Inflation Means to You
BlackRock: Investment Insight
Research Affiliates: Where’s the Beef? “Lies, Damned Lies, and Statistics

 

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About the author

John Shanley: CFP ® is a Financial Advisor with Pinnacle. He joined in 2015 after previously working as a Financial Consultant for Fidelity Investments. John is a Certified Financial Planner, a graduate of Fordham University and is currently pursuing his Masters degree in Financial Services. John is a native of Pawling NY and currently resides in Suffield with his wife, Jennifer, who is an Immigration Attorney. In his free time, John enjoys reading and is an avid hockey fan.


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