If there is one word that draws a shudder it’s inflation. Inflation is a dirty word in economics. Nobody likes to see the things they buy, like gas, food, clothes, and shelter, get more expensive. But like any economic cycle, inflation happens, and then it goes away.
Most economists are betting that current increases will only be temporary and are reflective of the ongoing coronavirus trends and supply chain issues. Still, the increase in prices is eye watering, and for those who are old enough to remember the economic havoc inflation wreaked in the mid-1970s and early 1980s, it’s not a word uttered without fear. But this is not 1980. Inflation is only a problem when it becomes sustained and pronounced. This hasn’t happened in decades, and it doesn’t seem likely to happen now.
But whether it is short-term or long-term, planning for inflation is an important part of an investor’s financial plan. Here’s three steps you can take to better protect your finances from a post-pandemic inflation boom, regardless of whether it’s temporary or sustained.
1. Don’t drastically change your approach, but keep a diversified portfolio with some inflation-safe investments
From an investing perspective you might not want to adjust your strategy all that much, particularly if you’re someone who’s in it for the long haul. That is why it is important to have a diversified portfolio that can work in every type of market. While there is no perfect inflation hedge, when you have a long enough time horizon, you can ride through times of higher and lower inflation. The inclusion of elements in your portfolio that typically perform well in inflationary environments can often be enough to weather the storm. It is important to remember that when inflation hits, there are not a lot of places to hide and price pressures could erode your wallet if you have too much exposure to cash and fixed-rate return investments. During these times, a well-diversified investor should not have to change their investment mix based on the direction of the wind, but instead continue to save and invest consistently with the goal of building a well-rounded portfolio.
Investing in a diversified portfolio of stocks is an excellent way to fend off inflation and lower risk. From September 2001 to September 2021, the S&P 500, a key benchmark for U.S. stocks, generated an average return of around 9.5% if dividends are reinvested. After accounting for inflation, you’re still looking at about 7% average annual returns. Another inflation strategy to include in a portfolio is shorter-term inflation linked securities. Where longer-dated bonds take a bigger inflation hit, incorporating bonds with a shorter maturity into your portfolio could help offset the strain. Another strategy can be incorporating inflation-indexed bonds, with the most common being Treasury Inflation Protected Securities, or TIPS. TIPS can protect you from inflation because they pay a fixed interest rate every six months and an inflation adjustment on a semiannual basis, which applies to the bond’s face value, rather than its yield. These strategies could provide a little bit more cushion than traditional bonds.
Those willing to look beyond the U.S. might find that emerging-market equities can also be a strong bet. But if all this seems complicated, there’s no real need to resort to picking individual stocks. An S&P Index Fund or S&P ETF can do the trick. Because they contain hundreds of stocks, they provide simple, low-cost diversification, which reduces risk and portfolio management headaches. As always, keep your risk tolerance in mind and don’t make too many gambles. Think about which companies have strong underlying fundamentals. When in doubt, think about the 2021 rise and fall of GameStop. When storm clouds are brewing, don’t chase the pot of gold at the end of the rainbow. Instead, put on your galoshes, open your umbrella, and prepare to ride it out. Be strategic and defensive, not reactionary
2. Save for poor economic conditions, but don’t keep too much cash on the sidelines
During times of high inflation, the U.S. economy is seldom a winner. But American’s have been down this road before. During recessions, the importance of an emergency fund becomes apparent. But during times of high inflation, it can seem like a bad time to park a lot of cash in a savings account. In the 80’s, certificates of deposit (CDs) had an impressive 18 percent annual percentage yield (APY), which was very good news for an emergency fund. But, with the high savings rates also came staggeringly high lending and 30-year mortgage rates. It was a classic example of money in, money out. At the end of the day, it’s always important to have an emergency fund that covers at least six months of expenses regardless of where savings yields, or inflation stand. But during higher inflationary environments, it is a particularly important time to make sure that you look to get a better return, especially for consumers, who are losing purchasing power.
3. Remember that not all inflation is wallet-harming, so try not to overreact
Inflation has never technically disappeared. Prices tend to rise every year, and for good reason. Too little inflation could lead to an economic downward spiral of deflation. Too much might mean consumers can’t afford their everyday goods and services with what they’re currently being paid. The goldilocks not-too-hot, not-too-cold rate is accepted to be around 2 percent annually. A healthy level makes paying debts easier, while also giving the U.S. central bank more room to cut interest rates during downturns. With 2 percent inflation, consumers can borrow and spend without overheating the economy. The greatest indicator of inflation in recent decades has been unit labor costs, and we’re looking at a labor market that has a lot of slack. When you have decades of disinflationary pressure, it’s very unlikely to see a rapid change.
A pick-up in inflation might be welcomed news for Fed officials, and possibly even American workers, if it means wages are climbing. But what’s clear about inflation is, once that plane takes off on the runway, it can be hard to turn it around. For those that are too heavily weighted in cash and fixed-income investments for their age and risk tolerance, this is a good time to review and adjust this before inflation, either now or in the future, becomes a problem.
Contact us to discuss how we can help you with your financial planning.