Inflation affects any market economy. Unfortunately, that also means it affects how you invest and why. Most people are aware that putting $10,000 in the bank means losing the buying power of that money over 10 years, but why? Inflation is the answer. That same effect impacts investments, how they earn, and what your eventual return is. After all, if you have to account for inflation as part of your investment, is it earning anything at all?
Calculating inflation is a significant and important part of investing. If you’re planning to save money for a few years, it only has a small impact. However, the longer you save and the longer you intend investments to earn for you, the more you have to take inflation into account. It’s important to ensure you have someone to calculate your potential returns to ensure your financial future is secure.
What is Inflation?
Inflation is the simple process of the value of a dollar becoming less. Rising prices allow companies to earn more and encourage investment in new ventures. Slowly rising prices, like the average 3.5% in the U.S. since 1969, encourage growth and is good for the equity market.
In the simplest terms, you’ve probably noticed how groceries, gasoline, or rent cost more year-over-year. That’s inflation at work. If you compare prices now to when you were young, there’s probably a considerable difference. While that, in part, also relies on product availability or supply and demand (e.g., televisions now are cheaper than in 1980 because demand is higher, mass production reduces costs, and the technology to produce them is lower) but simple goods like tomatoes or toilet paper cost significantly more. As Kiplinger.com points out, you could buy a stamp for 22 cents in 1985 and it averages 50 cents now. But, if you adjust for inflation, you were actually paying slightly more in 1985.
Some inflation is healthy and good for the economy. Too much inflation is bad for the economy, because it means everything loses value at a faster value than it appreciates value. Which is why the Federal Reserve works to keep inflation in check.
How inflation impacts investing
Inflation ranges between a low of less than 1% and a high 9%. In fact, in December of 2021, inflation was the highest it’s been since a peak of 12.5% in the 1980s. At 7%, few investment assets could keep up. But inflation for the year still averaged 3.7%. That’s important, considering the national average since 1969 has remained at 3.5%.
What does that mean for investment? If you don’t earn more than 3.5% in return, you’re likely not earning money, you’re losing it. That’s why gold has remained one of the most stable investment options you can buy. For example, with an average gain of 9.48%, you’re averaging a 7.08% return.
In addition, in some months or even years, any specific chosen investment is likely to appreciate at a lower rate than inflation. That happens whether you invest in stocks which have an average return of 10% but realistically a negative to 30%+ return in practice, gold, bonds, or anything else. But, if you were to put money in a savings bond with a 2.5% return over 5 years, chances are, it would be worth less when you get it out than when you put it in.
Inflation doesn’t affect all asset classes equally
Different types of assets are affected by inflation in different ways. However, this usually depends on their rate of appreciation. The higher appreciation rates or the more stable appreciation rates, the more protected an asset class is from inflation. Here, cash is always the most vulnerable. In fact, one of the best hedges against inflation is to invest in equities.
Similarly, while you do want to maintain fixed income exposure, returns on fixed income have been negative for most of the recent past. Here, you’re recommended to switch to floating rate bonds, which are essentially loans made to companies. Repayment rates are high, and as long as you get a 1-3% spread, you’re offsetting the negative impact of inflation.
Other assets like gold, real estate, Treasury-Inflation-Protected Securities (TIPS), and I Bonds are good ways to hedge your investment from inflation. In fact, you can get series I savings bonds today at 7% based on current inflation (Good place for cash). However, in most cases, the best strategy is to diversify and make updates to your portfolio based on changes in the economy such as inflation and interest rates.
Key Takeaways for Investing with Inflation
Inflation is a necessary part of the market economy. However, it can offset investments if inflation rises more quickly than your return. Hedging against that is important if you want to keep your financial future secure from the effects inflation. Here are some things you may consider:
- Investing in assets classes such as stocks with average return that is higher than inflation
- Maintain a diversified portfolio with proactive supervision to make changes as inflation rises or falls
- Invest in gold, commodities, TIPS, stocks, and real estate over cash and simple bonds
The longer you intend to keep investments, the larger the impact of inflation. For your retirement fund, it’s always important to look at projected inflation over your time horizon and to invest accordingly.
This information is for reference only and should be reviewed with a qualified professional as you situation may vary from others. Nothing mentioned above is a guarantee nor should this be considered advice.
Golden State does not and cannot deliver tax advice and the material herein is for information only. Please consult a qualified tax professional for opinions related to your particular situation.
Investment advisory services are offered through Golden State Equity Partners, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Tangent Retirement is a DBA of Golden State Equity Partners, LLC.
