Looking Forward: How Does Inflation Affect Investments
Thinking about retirement, it’s tempting to plan based on the prices of today. Given healthcare, living expenses, and of course leisure and vacation time, you think you’ll be comfortable living off of just $4,000 a month. Your current investments seem to be doing well and setting you up nicely for the life you imagine during retirement. Yet, that retirement isn’t for another 15 or so years and, like most people, you haven’t fully considered the effects of inflation on your future financial planning. How does it affect your finances? More specifically, how does inflation affect investments?
Inflation should always be something to consider when planning for the future, especially when it comes to the investments that will give you an income during retirement. Because of the nature of inflation, it lowers your returns. This means that a two-million-dollar investment now is not going to have as much worth later when there’s inflation. You might receive the same payout during retirement regardless of inflation, but your purchasing power will be weaker. A lower purchasing power is caused by inflation, which tracks the price increases of goods and services.
High inflation is the rising price of just about everything – from gas to groceries to rent. This is a problem for both investments and your future financial planning as you want to make sure your income during retirement is enough to cover your lifestyle.
Inflation As A Concern For Investors
Rising inflation is usually not beneficial for investments as it creates high-interest rates and the increase in prices of goods and services by the companies. Rising interest rates are caused by Federal Reserve, who uses short-term interest rates to remove some of the money from the market. One of the causes of inflation is too much money in circulation. However, if it’s more expensive to borrow money, then there’s less available to use, which slows the increase in prices.
Even with rising interest rates, inflation can still rise – just at a slower rate. The biggest issue with this is the drop in value of the dollar. Price increases are not always a negative thing for investors. If the price of a product rises due to popularity and supply and demand, that adds value to the investment. For example, the high cost of an Apple iPhone isn’t just due to the price of manufacturing or inflation. It’s also based on popularity, which increases the value for investors of Apple.
However, if the higher prices are due to inflation and no increase in value, then there’s a decrease in value for the investors. The goal with an investment is to increase returns and long-term purchasing power, but inflation puts this goal at risk. As inflation increases, the value of the investment diminishes, and the consumer ends up paying more for less because of the decreased value of the dollar.
During times of high inflation, companies seem to be doing well because their revenue and earnings increase with the rate of inflation. However, this is a smokescreen caused by inflation as, despite the increases in revenue and earnings, there has been no added value to the company. Even though rising inflation affects the interest rates and prices of companies you’re invested in, this doesn’t mean dropping your stock in a well-performing company. If a company is doing well despite inflation, stocks are still good hedges against inflation.
The Impact Of Inflation On Your Investments
Inflation can and should be a concern for investors, as it eats away at your savings and returns. This is especially true for those on a fixed income. When you hit retirement, your payouts may not be as valuable as you anticipate years before when you started building your nest egg. This means paying more for less. Your cost of living increases and your healthcare costs rise, making it difficult to live the retired life you imagined if you did not plan for inflation.
No investment is completely secure from inflation. It affects each asset differently.
- Cash Investments are probably the most susceptible to inflation. Many people prefer to keep their money in a savings account and readily available instead of investing it in non-liquid assets like stocks. However, high inflation rates mean a lower dollar value, which means your cash is not as valuable. Furthermore, the interest gained in a savings account does not keep up with the inflation rates. This means that not only the cash sitting in the bank losing value, it’s not gaining anything either.
- Debt Securities, or bonds and treasury bills, are not as affected as cash investments. To the investor that doesn’t like risk, they are slightly safer than having your cash sit in the bank unprotected from inflation. The high-interest rates caused by inflation makes debt securities look more attractive. However, your earnings still decrease as your purchasing power decreases with the rate of inflation.
- Stocks can be an effective way to counter inflation. Yet, inflation still affects the value of your investment the same as any other investment. The performance of a company determines the value of your stock. During times of high inflation, a company might seem to be doing well as revenue and earnings increase with the rate of inflation. However, this isn’t a true indication of performance. Moreover, the return value of the stock still decreases in the same way as any other return as purchasing power decreases.
- Property is the asset that has the most benefits during times of high inflation. Real estate prices rise with the rate of inflation. However, because most properties are bought with loans, higher interest rates could lower the demand of property due to the consumer wanting to borrow less. So, although the price of your house increases substantially with the increase in inflation, it might be more difficult to sell and reap the benefits of the return.
Protecting Your Investments And Your Future
There is no full-proof way to protect your investments against inflation. However, diversifying your portfolio can help protect your returns. This is because inflation impacts investments differently. However, a good financial advisor isn’t just going to look at your portfolio when planning against inflation. They should also look at your type of income and expenses. Inflation is a personal experience that changes just like your financial life; planning for inflation should reflect only your personal inflation.
At Vector Wealth, we apply inflation to income and expenses, not just in broad terms to your rates of return. We do this using our proprietary software, Sojourn. Inflation is a personal experience and so we make planning decisions based on those personal experiences. We adjust income and expenses – either through inflating it or deflating it – based on your life now and what you want to be doing in the future. Even as the years tick on during retirement, inflation may affect you less as you potentially spend less. This means adjusting your income to cover your expenses, which also includes healthcare costs. Although inflation affects everyone and everything differently, there are ways to counter the effects through good financial planning.
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Vector Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.