I’m pretty sure every reader has a pretty good understanding of inflation. In general terms, things cost more as inflation rises so that a fixed amount of money buys fewer things. And from an investment point of view, a portfolio worth a certain amount of money will buy less as inflation rises.
Inflation is measured in a variety of ways. For most of us, the most familiar measurement is the Consumer Price Index. The CPI increased from January 2017 to January 2018 by 2.07%. This is pretty good as most industrialized governments attempt to keep inflation between 2% and 3%.
The overall CPI is an important measure of spending power. However, it’s also important to look at the sub-groups that make up the CPI. For example, over the last twelve months housing increased 2.79%, medical care increased 1.98% and education and communication decreased 1.73%. So, if you’re retired and have paid off your house, the housing component wouldn’t be that important whereas heath care would be quite important.
What does inflation mean to our investments? To understand that, we need to understand the difference between nominal and real interest rates. Nominal interest rate is the growth of your investments. Real interest rates represent your investment growth after inflation is taken into account. As an example, suppose inflation is running at 3.5% and your portfolio is currently returning 6%. Nominal is 6% and real is 2.5% (6% – 3.5%). The important lesson here is to think about the real rate of return since that represents your purchasing power.
For many of us, our investments can be divided into stocks and bonds. It’s generally accepted that over the long run, stocks are able to cope with inflation fairly well. Bonds on the other hand usually suffer as inflation rises. This hasn’t really been true during the last few years, but normally rising inflation leads to rising interest rates. And as interest rates rise, fixed-income investments like bonds lose value since a new bond has a higher rate of return than an older existing bond. Now there are some important nuances here. One example is when you hold bonds that yield at least your targeted withdrawal rate in retirement. Suppose your retirement plan is to withdraw 3.5% per year from your portfolio. Now if your returns are higher than that, your earnings are less than the current yield, but still high enough to meet you goals.
You can see that inflation matters and that the best defense depends on whether you’re retired or not as well as other factors. We’d be happy to talk about inflation and your particular situation or any other financial matters in a no-charge, no-obligation initial meeting. Just visit our website or give us a call at 970.419.8212 to learn more.
This article is for informational purposes only. This website does not provide tax or investment advice, nor is it an offer or solicitation of any kind to buy or sell any investment products. Please consult your tax or investment advisor for specific advice.