U.S. consumer prices soared 7% in 2021, the largest 12-month gain in the past 39 years.1 In addition, annual inflation is now sitting at 7.5%. If you’re concerned, you’re not alone.
Following are some inflation considerations for your financial life, including your investment portfolio and your day-to-day expenses.
The impact of inflation on your investment portfolio
Imagine you have $1 million saved, and you live in a fantasy world where there are no taxes.
You need to take out $40,000 each year for expenses. This is a very reasonable 4% starting withdrawal rate, and it assumes you can get 5% a year risk-free and tax-free on your investments, with inflation at 3%.
Everything should be fine, right?
Indeed, after 10 years your balance has grown to about $1.06 million, and you feel comfortable. Then a funny thing happens. Your balance starts to decline, slowly at first and then faster. You are broke after 37 years.
What happened? Even though the rate of appreciation on your investments was higher than inflation, because the money you spent was not able to grow, the inflation rate on the expenses eventually overwhelmed the portfolio. Had inflation only been 2%, it would take 48 years to go broke. Only when inflation is down to about 1% does the portfolio continue to grow indefinitely in this scenario.
Inflation is one of the greatest destroyers of wealth in the history of the world. It should be a consideration when you are planning your financial future, especially regarding asset allocation decisions.
Due to the power of compounding, inflation can have a much greater impact in long-term horizons than it does in short ones.2 Especially if you have a long time horizon (more than 30 years), one shouldn’t assume that everything will be fine as long as your investment return is higher than your original withdrawal rate. If inflation rears its ugly head, even if your returns outpace it, you may still run into trouble.
How to manage inflation
Inflation is inevitable, but there are steps you can take to help reduce its impact on your portfolio. Below are just a few strategies that, while they won’t stop inflation, may help mitigate its harmful effects.
1. A diversified portfolio
You won’t be surprised to learn that investing is one of the best ways to help protect yourself against inflation. But just as important as investing are the assets that you choose to invest in.
Investing in stocks is one way to help mitigate against inflation. Over the past 30 years, the average annual inflation rate has been about 2.31%.3 But the average return of the stock market over long periods of time is about 10%.4 By investing in stocks, you can potentially match inflation.
TIPS — or treasury inflation-protected securities — are fixed-income securities that increase in value over time with inflation (or decrease with deflation). Like other fixed-income securities, TIPS make biannual interest payments, and those interest payments are based on the inflation-adjusted principal. While TIPS won’t make you rich, they may help you keep pace with inflation.
In addition to keeping stocks and fixed-income securities in your portfolio, consider adding alternative assets to help you hedge against inflation. Commodities and real estate, for example, tend to hold their value and increase with inflation.
Cryptocurrencies such as Bitcoin and Ethereum are high-risk, speculative investments. Bitcoin’s limited supply could make it a powerful inflation hedge, but for the foreseeable future, price swings and overall level of acceptance will be what matters.5
2. Cash savings
You’ve probably read countless articles about the importance of saving money and building your emergency fund. And with the emphasis the financial community places on savings, you may be surprised to learn that it’s possible to save too much.
Here’s the problem: When you keep your money in a checking or savings account — even a high-yield savings account — your returns may not keep up with inflation.
Based on data released at the end of July 2021, inflation for the previous 12 months equaled 5.4%.6 During that same time, the rate available in many high-yield savings accounts was just 0.50%. So, while your savings may have grown more quickly than if you kept them in a checking account or traditional savings account, your returns paled in comparison to the inflation rate.
When it comes to deciding just how much cash to keep on hand, consider limiting your savings to your emergency fund (generally three to six months of expenses) and any money you expect to need in the next few years. Beyond that, consider investing your money where returns may have the potential to exceed the inflation rate.
3. Debt payoff plan
High interest debt should almost always be paid down as aggressively as possible. With low interest debt, consider the financial impact of prioritizing investing instead. While inflation often works against you, in the case of debt, it may actually work in your favor.
Look at it this way: Imagine you borrow $10,000 at a low interest rate to help pay for college. The $10,000 you repay to the lender won’t be worth as much as the $10,000 you borrowed. Even when you consider interest, the amount you repay is worth less than it was at the time you took out the loan.
Now consider paying off a mortgage worth several hundred thousand dollars. Your interest rate might only be slightly higher than the rate of inflation, but it’s likely less than half of the return you could be earning in the stock market. Keep in mind this all depends on how low the interest rate is on the debt.
That’s not to say that paying off debt isn’t important, and achieving debt freedom can help free up money in your budget, which also increases your purchasing power. But it may not be worth foregoing investing until you’ve managed to pay off all your debt first.
4. Your income
While significantly increasing your income may seem easier said than done, it’s one of the best ways to protect yourself against inflation. In fact, increasing your income at a rate that at least equals the rate of inflation is the only way to maintain or grow your current purchasing power.
So, what are some of the best ways to increase your income?
First, look for opportunities in your current workplace to earn more money. You can negotiate for a raise in your current position, or even look for promotion opportunities.
You can also increase your income by applying for a job at another company. In fact, data suggests that full-time workers can increase their income at higher rates by switching jobs than by getting a raise in their current job.7
Other ways you can increase your income include starting a business, switching career fields, picking up a side hustle, or investing in advanced education to further your career.
The bottom line
We often don’t even notice inflation as it’s happening. You may not realize that a gallon of milk has gotten slightly more expensive or that an item you paid $100 for last year now costs $105.
But just as investment returns compound to help you build wealth, inflation also compounds to whittle away at your savings. Unfortunately, there’s nothing we can do to stop inflation. In fact, a little inflation is considered the sign of a healthy economy.
But luckily, the steps above can help you to reduce inflation’s impact on your portfolio and your financial future.