A few years ago, a story hit the newsstands about a coat somebody donated to Goodwill with $43,000 in the pocket. Wouldn’t it have benefited the owner more if she had kept her cash in investment vehicles rather than the proverbial mattress? In this article, we explore the risks of not allowing your cash to keep up with inflation and how inflation impacts your savings and investments.
Inflation Defined
Let’s start with a definition. Inflation is the rise in prices of everyday goods and services. Put differently, the purchasing power of a single dollar falls when the price of goods and services goes up. For example, if a car costs $20,000 today and the current inflation rate is 2%, that car will cost $20,400 next year, assuming the price goes up in line with inflation. The Consumer Price Index (CPI)—a measure of the average change over time in the prices paid by urban consumers for a market basket of goods and services—is the most popular measurement of inflation. According to the Bureau of Labor Statistics, from December 2019 through December 2020, the CPI for all urban consumers (representing 93% of total U.S. population) rose 1.4%, which is the smallest increase since 2015, which saw a 0.7% increase.1
Over the course of American history, we have experienced both inflation and deflation. The Federal Reserve (Fed), which is charged with monitoring and implementing monetary policy with respect to inflation, does not have a set number for an “acceptable inflation rate.” Most economists, including many of those at the Fed, think the informal consensus by policymakers is an inflation rate around 2%.2 Following a prolonged period of rising inflation after World War II until the late 1970s, inflation has been on a steady decline (see chart below), almost to the point that some observers wonder if it is gone as a fixture of the economic scene.
Impact on Your Savings
When markets are volatile, as they have been over the past year, it’s easy to understand why investors may choose to hold large amounts of cash, particularly if inflation is not an issue. Cash is viewed as a safe option in terms of maintaining its principal value. If, however, inflation returns, there is greater risk that cash will not maintain its purchasing power. Here’s an easy way to understand the impact of inflation on your savings: Let’s say you have $1,000 in a savings account that pays a 1% interest rate. In a year’s time, your balance will grow to $1,010. But if the rate of inflation is 2%, you would need $1,020 to have the same purchasing power that you started with. When the growth in savings does not increase at the same rate as inflation, there is no loss of nominal value, but those savings will not buy as much as they did the year before. One would have to save more or accept a smaller net worth over time because inflation is decreasing the purchasing power of the capital, as the following chart shows.
Impact on Your Investments
The impact of inflation on your investments depends on the type of investment.
Bonds: Bonds have an important place in many investors’ portfolios, particularly for those in retirement (or approaching retirement) as they can serve as guide rails to brace your portfolio in periods of stock market volatility. Bonds are not, however, immune to the impact of inflation. The purchasing power of the cash received from your fixed coupon payments will decline unless you reinvest the coupon payments at successively higher interest rates and/or into a diversified portfolio of stocks. In an inflationary environment, a comparatively low yield on bonds will have trouble competing with the higher cost of purchases. In addition, it’s important to keep in mind that, relative to shorter-term bonds, longer-term bonds carry a greater risk that higher inflation could reduce the value of payments to the investor over the life of the bond. There are bonds, however, that can help protect against inflation. Treasury Inflation Protected Securities, or TIPS, were designed to do just that. These bonds, which have U.S. government backing, are indexed to inflation and pay investors a fixed interest rate as the bond’s par value adjusts with the inflation rate.
Stocks & Commodities: Stocks also play an important role in portfolios and, historically, they have demonstrated better real returns compared to bonds in rising or high inflationary periods.3 However, inflation can directly impact stocks in two opposite ways that can largely offset each other, thus providing a hedge against inflation.
The first way inflation can affect stock prices is by causing a decline in their value. This has to do with how we value the future income for each company. When you buy a stock, you are purchasing the future cash flows of the company based on its profits. The value of the company (and its stock price) is based on what those cash flows are worth today. This calculation is referred to as a stock’s present value and is determined by discounting those future cash flows at a rate which factors in the impact of inflation and interest rates. So, if inflation rises, all else being equal, the discount rate used in the calculation will be higher, which will make the present value of the company lower, which may cause its stock price to decline.
Conversely, inflation can impact stocks by causing the value of stocks to increase in value. When inflation occurs, a business often can pass along the higher prices it incurs running its business to its customers. This can lead to growth in its profits and higher cash flows, which in turn can lead to a higher present value for the company and to an increase in the stock price over time.
Commodities and real assets are also considered a way to offset the impact of rising inflation. That’s because their prices typically rise when inflation is accelerating thereby offering protection from the effects of inflation. Commodities include items such as gold and silver or futures on food, energy, or industrial materials.4
How to Mitigate the Impact of Inflation
As an investor, you can focus on how your investments are allocated across various asset types to mitigate loss of purchasing power over time. Although it is prudent to have a reserve of cash to cover emergency expenses and three to six months of living expenses in the event of a job loss, be aware that while a dollar in a savings account may not appear to lose value over 10 years’ time, the veiled reality of that dollar being worth less money should not be overlooked.
At SBH, we have CFP® professionals who can help you model the impact of various asset allocations in different economic scenarios to determine the asset allocation plan that is most appropriate for your situation. We would welcome the opportunity to speak with you. Please feel free to contactus@sbhic.com or call us at (800) 836-4265.
1 https://www.bls.gov/news.release/archives/cpi_01132021.pdf
2 https://www.federalreserve.gov/faqs/5D58E72F066A4DBDA80BBA659C55F774.htm
3 https://money.usnews.com/investing/investing-advice/slideshows/investments-to-offset-potential-inflation?slide=3
4 https://money.usnews.com/investing/investing-advice/slideshows/investments-to-offset-potential-inflation?slide=4
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