What is inflation and what does it mean for your financial plan?

By Massi De Santis

You may have noticed that it costs almost twice as much to refuel your car at the pump compared to last year, or that the bundle of rib eye steaks you get every week is getting expensive. . On average, depending on the Bureau of Labor Statistics (or BLS), the cost of living has increased at a rate greater than 5% in the past 12 months. This unusually high number (inflation has averaged around 2% per year for the past 20 years) has made headlines and you may be wondering what this means for your retirement plan and for your future investment returns.

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Before you panic about inflation and make drastic changes, however, it helps to understand how inflation works and how it can impact your investment plan. Here’s a quick look at inflation and how you can plan for it.

What is inflation?

Inflation is a general increase in prices and the cost of living. Over a period of time, the prices of some of the goods we consume go up (think a gallon of milk or a box of cereal) while others may go down (the price of televisions). Inflation measures the mean price increase. If prices increase on average, it becomes more expensive to buy the same goods and services as before the price increase, hence the cost of living increases. The Bureau of Labor Statistics publishes the most common price measure, called the Consumer Price Index or CPI.

When prices go up, the cost of living goes up and so does the CPI. The CPI uses more than 200 categories of goods and services divided into eight major categories and collects the prices of these goods on a monthly basis in 75 different metropolitan areas. The BLS then constructs the CPI by weighting the prices of each of the goods and services according to what a typical household spends on each. For example, the typical household in the BLS sample spends 15% on transport, so the transport category gets a weight of 15%. Below is the breakdown of the latest IPC Basket.

Pie chart of Desantis

The main sources of inflation over the past 12 months have been energy costs, including gasoline and utilities, and transportation, including used car prices. More recently, you may have noticed higher prices in grocery stores and restaurants. There may be differences between states and regions of the United States, resulting in different baskets and different changes in the cost of living. The BLS website makes information about the CPI available to a regional level.

Why is inflation bad?

The most obvious effect of inflation is that it decreases the purchasing power of your income, or real income. For example, if you got a 3% raise at the start of 2021 and the cost of living goes up 5% this year, your actual income goes down by about 2% this year. While income tends to adjust somewhat to inflation over time, not everyone’s income will change with inflation, so high inflation can mean a decrease in your income. real income, which can be particularly harmful for a retiree living on a fixed income.

Another cost of inflation is that it increases effective tax rates. Income increases caused by inflation can put you in higher tax brackets while your actual income stays the same. Inflation also increases the taxation of your investments. Suppose your return is 5% when inflation is also 5%. Your actual return is zero because you earned just enough to cover the increased cost of living. However, you are taxed on the entire 5% return.

There are also more general costs associated with inflation. In times of high and unpredictable inflation, economic growth and stock returns tend to be lower. During the decade between January 1970 and December 1979, inflation averaged 7.4% per annum, while the S&P 500 index averaged 5.9%, below inflation and below its long-term average of over 10%.

There are some positive aspects of periods of inflation. If you have a fixed rate mortgage, your monthly payments relative to your (inflated) income will be lower. And in many cases, at least if inflation is temporary, you can significantly reduce its negative impact by changing your spending habits, as we discuss below.

Government policy and inflation

Government policy, whether monetary or fiscal, tends to be inflationary. The increase in government spending financed by the purchase of government bonds by the Federal Reserve (“Fed”) is inflationary. The Fed’s purchases of existing government bonds to increase the money supply can also be inflationary, especially if the Fed insists on reaching maximum jobs. If inflation gets out of hand, historical experience shows that the cure may take time and lead to slower growth and higher unemployment for some time, as we experienced in the 1970s and early 1980s. 1980s.

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What can you do?

You might be tempted to keep up with the news and various experts trying to predict inflation and choosing investments that might do well if inflation rises. However, historical experience shows that, unfortunately, we cannot predict the future of inflation with any reliability. We can only hope that the Fed will use its tools to bring inflation under control, and not necessarily that they will. Likewise, don’t rush to buy gold or other commodities to protect your nest egg against inflation. Studies show that gold is not a good “hedge” against inflation for most investment horizons. Current prices also show that gold is expensive relative to the CPI, based on historical evidence (the current gold / CPI ratio is 6.5 versus the historic 3.5). So what can you do? Here are some suggestions that are not prediction of the future.

Make a plan

If you’re worried about inflation, make sure you have a good financial plan in place for your goals. Whether you’re planning for future retirement, assessing your retirement readiness, or estimating how much you can safely withdraw from your nest egg, a financial plan that takes into account multiple inflation scenarios through a Monte-Carlo simulation is a good way to prepare for inflation risks. Historically, we have experienced periods of high inflation and low inflation, high interest rates and low interest rates, etc. Your plan should be robust to a range of scenarios.

Stick to the planning process

Making a plan is the first step, but planning is a process. Be sure to revise your assumptions and plan as your financial situation evolves. Right now, you might want to pay more attention to spending related to rising inflation, as we suggest below. But inflationary fears can be temporary. The economy may get back on track and you may get a bigger increase than you expected, or your returns on your investment may be better than you expected. You should allow for flexibility in your plan and revise it often, once or twice a year.

Make a budget and track your expenses

A budget tells you more about your spending habits and can help you find opportunities to save. Check out this article to create your first budget or this one to help you track your expenses. Here are some ways to reduce expenses during times of high inflation. First of all, keep your durable goods longer. Wait until you buy your next car if you can, to avoid temporary price pressure. Buy a second hand. You probably don’t need a brand new SLR camera or ATV if you’re just trying out a new hobby. The local Facebook Marketplace is a great place to shop.

Cut down on your driving and save on gasoline, which has increased by more than 30% in some parts of the country. Take a hike and check out what your neighborhood has to offer. If you need to refuel, depending on gasbuddy.com, a website to help you save on gasoline, Mondays and Tuesdays are historically cheaper days for gasoline. Finally, if you love to travel, explore cheaper destinations to save on travel and explore places closer to home.

Refinance your debt

If you haven’t yet taken advantage of historically low interest rates, you may want to consider refinancing your mortgage or other loans. Low interest rates mean that the price of borrowing money is particularly low. Reducing the costs of your loans means that you have more money to meet other costs that may increase.

Review your portfolio

I put this one last because a good portfolio allocation should always factor in the effects of inflation, regardless of the headlines. A retirement portfolio should have some exposure to inflation-protected treasury bills, or TIPS. Unlike gold or other commodities, TIPS are a good hedging instrument because bond payments are adjusted by the actual CPI. Although limited to smaller quantities, I-savings bonds are also a good inflation instrument to consider and may give you higher returns than TIPS.

Finally, long-term investing benefits from exposure to equities. Historically, stocks have outperformed inflation and commodities like gold over the past 50 years. The amount of stocks versus bonds should depend on your goals and time horizon, and not so much on current inflation fears, so start there.

You get the point. The bottom line is that there is no silver bullet to unexpected inflation. This is quite simply one of the risks that investors should take into account when developing their investment strategy. If you don’t have a strategy or would like to revisit yours, start by checking out our discussion of the risk-return tradeoffs of investing and how to develop your own investment guidelines.

About the author: Massi De Santis

Massi De Santis is an Austin, TX paid financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides an objective financial planning and investment management to help clients organize, develop and protect their resources throughout their lives. As an independent, fiduciary and independent financial advisor, Massi De Santis never receives a commission of any kind and has a legal obligation to provide impartial and trustworthy financial advice.

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