Why is inflation so important to understand?
Inflation is a monetary measure of how much the overall value of your money goes up over time. The concept of purchasing power is an important economic concept. It can indicate whether you should be concerned about your purchasing power, or whether you should focus on the rate of return you’re earning from your investments.
If an economy experiences a period of high inflation, prices for goods and services tend to rise rapidly. Due to its unpredictable effects, it generally has a negative impact on you and the economy.
What is inflation?
Undoubtedly, over the last few months, you have read or heard much about inflation. It becomes concerning for investors and consumers when they see the prices of everyday goods on a continual rise. So, this is a good working definition of inflation--a sustained increase in prices of goods and services.
Inflation is a problem for investors because it makes everything cost more. That means your returns are less, and you have to save more. Let's explore how inflation works and how it affects you as an investor.
As we stated earlier, inflation is the increase in the general price level of goods and services, measured over time. In the United States, inflation can be measured using the Consumer Price Index (CPI). This index shows the percentage change in the price of a basket of goods and services purchased by U. S. consumers in the past year. There are thousands of different goods and services that the CPI is measuring giving an overall statistical snapshot of what is going on in the U.S. economy.
If you go to the Bureau of Labor Statistics you may notice there are different measures of inflation. Not only do they track the Consumer Price Index (CPI), you will see Producer Price Indexes (the changes in the selling prices received by domestic producers of goods, services, and construction), Import and Export Prices, and Chained Consumer Price Index (C-CPI-U). All of these various measurements are seeking to understand the health of the U.S. economy and how it is impacting consumers and businesses.
What is the relationship between inflation and interest rates?
Inflation rates and interest rates are directly related. When the inflation rate is high, interest rates are also high. When inflation is low, interest rates are also low because lenders are less likely to demand high interest rates for loans because the return on these investments will be less.
Inflation and Interest Rates in the United States: A Brief History
Often in the news, we read about how the Fed (Federal Reserve) set a target interest rate in which banks borrow and lend money to each other. This rate often has an economic effect and can be felt across the entire US economy. Though it may not cause an immediate economic impact, the market often reacts immediately since the market is like an information processing machine since it takes this new information and responds accordingly. Why? Because the market is composed of investors who react to new news.
It makes sense that interest rates are tied to inflation. The higher the interest rate, the greater the inflation since borrowing money is more expensive. Inflation will impact how the Government receives its revenue via taxation as well as the increased spending needed for all of the federal programs.
What is the relationship between inflation and the stock market?
Stocks should theoretically provide some hedge against inflation, because companies' revenues and profits should grow with inflation over time after a period of adjustment. Researchers at the Leuthold Group, looked at market performance since 1945 and found that when inflation is high, stocks tend to perform well right after the inflation rate peaks. (Source here)
However, investors should be aware that this is not a guarantee since it is difficult to predict future market performance and the impact inflation has on stocks and bonds. The key is to have a prudent diversification strategy and review that strategy in light of past history of inflation rates and stock performance. This is not to suggest that past history is a guarantee of future performance, but looking at the past regarding the overall market and inflation rates, you will have a better understanding that investors, like you, have been through this before.
Lastly, since inflation causes prices to rise, which reduces consumers' purchasing power, you will see a lower demand for goods and services (which leads to slower economic growth). This of course can lead to lower corporate earnings as companies raise prices to cover rising costs.
What are the consequences of inflation?
With the increase in prices caused by inflation, how can we, as investors (and consumers) protect ourselves from its effects?
When inflation starts, people start getting worried. It becomes a natural reaction to worry and fret about savings and investments. Investors and consumers may find themselves buying less than they normally would. They may resort to a refocused effort on budgeting. In fact, according to the Morning Consult survey, more than 80% of US consumers are eating out less.
It's easy to see how this behavior impacts the economic participation of investors. Whether it's the rising costs of goods and services, or the overall volatility of the market, many become consumed with fear.
One important thing to note is that when the money supply increases faster than the economy, the inflation rate climbs since there is more money chasing fewer goods.
Are stocks a good investment during times of high inflation?
Stocks have historically been good investments in periods of rising inflation because they tend to appreciate more quickly than inflation. While they may not always rise as fast as inflation, they are typically worth more than inflation rates over the long term.
SimpleStockInvesting has an excellent illustration on the impact of staying the course:
“The effect of investing $1 in 1950 is seen. The orange curve shows the result of having all dividends reinvested (i.e., the total return), while the blue curve disregards dividends, therefore reflecting only the evolution of price. As can be seen, reinvesting all dividends produced about 8 times the return. Note that the y-axis is logarithmically scaled, for better appreciation of the earlier trends.” (Source here)
How do you manage your portfolio during inflation?
You should diversify your portfolio. Always.
Make sure you understand the risk you are taking regarding your current mix of holdings--this is referred to as your asset allocation. Focus on the long-term since the economy and market moves in cycles.
The best way to diversify your portfolio is to invest in a broad range of assets. If you want to diversify your portfolio, then you should be investing in a broad range of assets such as stocks, bonds, and real estate. It's important to understand that diversification will help reduce the risk that you will lose money because you are exposed to more than one asset class.
It bears repeating that there may be the temptation during inflationary times to chase the performance of individual stocks. This is often caused by the desire that we have to do something since the market is “doing something.” Individual stock picking is often a loser’s game since it is near to impossible to find undervalued stocks when compared to the market as a whole. As the great Warren Buffet once said, “I do not think the average person can pick stocks.” His reasoning is based on a long line of research stretching back over 50 years that shows individuals when compared to a simple index fund underperform.
The importance of following a financial plan
As we have stated in our previous post - there are several benefits to following a financial plan.
Some of the main benefits include: It will help you stay on track financially. It will help you avoid unnecessary spending and worry that comes from volatile markets. It will help you to make better decisions about your money. You will be able to better plan for retirement. It will allow you to budget your money properly.
[link back to financial plan article on site]
What should you be doing right now to protect your portfolio?
There are a few things you can do to protect your portfolio:
Step 1: Review your investment goals
You should have an overall financial plan that determines whether you are on target to reach your goals or not. If you aren't meeting your goals, ask yourself why. If not, have a clear understanding of what you are investing in and why they are in your portfolio in the first place.
Step 2: Ignore the financial press
The financial press is full of financial advice. Ignore it. It's not based on reality. It's based on hype. You can't control the market or the economy. You can only control what you do.
Inflation impacts investors due to rising prices of goods and services. A prudent strategy for any investor during times of inflation is to ensure they have a solid financial plan in place. This financial plan takes into account the income and spending needs in light of any economic cycle that is being experienced at the time. A prudent financial plan has already contemplated and accounted for this. What is needed is for the investor to stay the course and commit to the plan.
If you have any questions regarding your plan and how your portfolio is designed to weather any market cycle, please contact us here. We are here to coach and walk with you.