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Written by: Juan Toran
Imagine a world with no inflation. Prices for everything from groceries to gas rise steadily over time, and this can make life more difficult as we age - especially if our income doesn't keep pace!
You may have heard people talking about how high prices went last year or what they'll be like next month; but do you really understand the term "inflation"?
Inflation has been around as long as currency has been around, especially with fiat currency systems (but more on this later). Inflation is typically measured by tracking the Consumer Price Index (CPI), which measures the weighted average of a basket of goods and services deemed to be of primary need.
Story Time
Last weekend my eleven-year-old told me she really liked reading “The Giver,” by Lois Lowry. I remembered reading it around her age, as well as another title by the same author, “Number the Stars.” An avid reader growing up, I still had the copy I read as a child over two and a half decades ago. She found it on the living room bookshelf and I chuckled as I saw the price on the cover: $2.99. A quick search online showed me that the current best price for the same book in a paperback format is $7.99.
The price of this particular book has increased over 260% in the last 25 years. If we were to snap a chalk line to determine what the average yearly price increase for this book is, we would find it to be in the ballpark of 4.2% per year.
Causes for Inflation
At its core, inflation is driven by increases in the supply of currency in the system. This can occur through various mechanisms. At the time of this writing, the world is still feeling the effects of the monetary policies designed to protect national and global economies from collapsing in 2020. The principal causes for inflation in the United States during these times have originated both from the increase in the supply of currency and the decrease in the supply of goods and services. Simply put:
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In 2020 the Fed began injecting dollars into the economic system by purchasing previously issued treasuries from banks. This gave the banks more dollars, which combined with the lowering of interest rates, flooded more money into the economy, driving demand.
Conversely, supply chain issues and disruptions in production caused by COVID-19 (and now the conflict in Ukraine) slowed the supply of many good and services. This, paired with an increase in demand, drives prices up.
Why it Matters in Your Accumulation Years
In your working years, you are compensated for the goods or services you produce. This compensation is what you use to fund your current lifestyle and (ideally) your investments and retirement accounts.
For this reason, most people expect (at a minimum) somewhat regular Cost Of Living Adjustments (COLA) over the years (net of performance tracking and/or job changes) in order to maintain their purchasing power. These adjustments unfortunately happen after the fact, which can mean a tightening of the belt in times of higher inflation.
Why it Matters in Retirement
Your fixed sources of retirement income can include Social Security and pensions. While the Social Security Administration increased benefits 5.9% this year to help with rising costs of living. Similarly to the wage adjustment described above, these happen after the fact.
Pensions (and other similar retirement vehicles) may have different treatments:
- increasing payments
- level payments
- lifetime payments
Depending on what your options are, you may find yourself needing to supplement your income in order to maintain purchasing power.
Inflation Linked Securities
One way to manage the effects of inflation is through what are known as “inflation linked securities.” These are investments that change in value based on a particular index, such as the CPI. They can take many forms, including mutual funds and ETFs (exchange-traded funds), which may track other indexes such as commodities, precious metals, and Treasury Inflation-Protected Securities (TIPS). By investing in inflation linked securities, you can help protect your purchasing power as prices rise over time.
Whether you find yourself in a position where you need to manage the effects of inflation during your accumulation or retirement years, it is important to be aware of what inflation is, causes for inflation, and inflation linked securities.
Recency Bias
In a recent podcast release by Matt and Brad on Every Day is Saturday, they discuss the recency bias, or the way we as humans tend to feel like everything will always be the way it has just been or is freshest in your memory, and how that affects investors with regard to inflation in times like these. Because inflation has been a driving force for the last several months, we tend to believe it will always remain this way. We must pause and remember that this, too, shall pass.
What You Should Worry About
As investors, we need to remember that our goals are long term, and moments of such high inflation have historically been short term issues. Is your portfolio built in such a way that you are protecting the money you need in the short term while investing wisely for the mid term and not losing site of the long term growth? Does it exist in a cohesive environment with parameters in place to protect you against external forces, such as inflation?
With the long term in mind, investors need to find a balance between investing in the sectors driving inflation while limiting the exposure of their portfolio to the volatility of the current market environment; and not let fear be the driving force behind their decision.
Related: Annuities: What You Need to Know