Crisis Proofing Your Financing

Crisis-Proofing Your Finances: Confronting the Inflation Menace

In the world of personal finance, one term stands as a nemesis to the best investors and the most diligent savers- inflation. It's a silent force that erodes the purchasing power of your hard-earned money, reduces the value of your investments and can jeopardize your long-term financial security. It’s not just a topic for economists and policymakers- it's a financial reality that affects us all.

In this article, we will:

• Understand how inflation affects your savings and investments long term.

• Explore the various financial planning scenarios where inflation plays a pivotal role, from retirement planning to handling rising education and healthcare costs

• Discuss strategies to mitigate inflation's impact on your investments and long-term financial goals

What exactly is Inflation?

At its core, inflation is the gradual increase in the general price level of goods and services in an economy over time. When inflation occurs each unit of currency buys fewer goods and services than it did before. A dollar could buy two pounds of vegetables back in 2006. Today you can barely get a pack of gum. Ignoring its effects can lead to unexpected shortfalls in your financial goals and a lower standard of living in the future.

Historical Context

Inflation has occurred several times in the past. Here are some of the more extreme cases:

• Weimar Republic Hyperinflation: One of the most popular cases, and perhaps the most extreme case of hyperinflation, the Weimar Republic in post-World War I Germany witnessed currency devaluation so severe that people used cartloads of banknotes just to buy basic goods.

• 1970s Stagflation: The 1970s saw a unique combination of high inflation and high unemployment, referred to as stagflation. Factors like oil price shocks and expansionary fiscal policies contributed to this period of economic turmoil.

• Zimbabwe Hyperinflation: In the late 2000s, Zimbabwe experienced hyperinflation that rendered its currency virtually worthless. Citizens faced the challenge of affording daily necessities as prices skyrocketed.

Measuring Inflation

Central banks and policymakers walk a very tight line when discussing how to control the inflation rate.

In developed economies, moderate inflation within a target range (often around 2%) is considered healthy for economic growth. It encourages spending and investment while allowing central banks to use interest rates as a tool to manage the economy.

Hyperinflation, on the other hand, is an extreme and uncontrollable form of inflation where prices soar at astronomical rates, often exceeding 50% per month. It can undermine trust in the currency and lead to economic and social instability.

Economists and policymakers use various measures to track and quantify inflation. Two of the most common metrics are:

Consumer Price Index (CPI): The CPI measures the change in prices paid by consumers for a basket of goods and services. It tells us how the cost of living is changing for the average person.

Producer Price Index (PPI): The PPI on the other hand measures the change in the selling prices received by domestic producers for their output. It indicates inflationary pressures at the wholesale (or producer) level.

Economic policies are also followed. It’s split into two parts:

• Governments usually enact policies that influence inflation rates. Expansionary fiscal policies, such as large-scale stimulus packages or deficit spending, can boost demand and potentially contribute to inflation. Similarly, trade policies, tariffs, and subsidies can influence the prices of imported goods and domestic industries.

• Central banks control inflation through their monetary policies. When central banks raise interest rates, borrowing becomes more expensive, which can slow down spending and curb inflation. Conversely, lowering interest rates stimulates spending but may exacerbate inflation. Understanding the intentions and actions of central banks can help investors anticipate and respond to inflationary pressures.

How does this impact your Long-Term Financial Planning?

Let’s suppose you want to retire comfortably in around 30 years. You plan to save up one million to maintain your lifestyle. But if the inflation rate is at 2% every year from now till then, you would retire with just about $550,000– half less than what you planned for. Inflation has that impact. Below we discuss three main areas where most individuals like to invest for their future, and how inflation affects them:

A. Impact on Cash Savings

Like our example above inflation gradually erodes the purchasing power of your cash savings. Suppose you have $10,000 saved in a bank account with an interest rate that doesn't keep pace with inflation, which is typically the case with traditional savings accounts. If the inflation rate is 3%, the real value of your savings effectively decreases by that percentage each year. So, after a year, your $10,000 will have the purchasing power of $9,700, and this erosion compounds over time.

B. Impact on Fixed-Income Investments

When you invest in a bond, you lend money to an entity (e.g., government or corporation) in exchange for periodic interest payments and the return of your principal at maturity. But if the interest rate on the bond doesn't keep pace with inflation, the real value of the interest income and principal repayment decreases over time.

To account for inflation, it's crucial to consider both nominal and real returns on your investments. Nominal returns are the actual returns you earn, while real returns factor in the impact of inflation. If your bond yields 4% in interest income but inflation is at 3%, your real return is just 1%. This means your money is growing at a slower pace than the cost of living is increasing.

C. Impact on Equities and Real Assets

In some cases, stocks can serve as a hedge against inflation (take blue-chip stocks as an example). Companies may be able to pass on increased costs to consumers, leading to higher revenues and profits. But severe inflation can also lead to market volatility and uncertainty- which affects stock prices.

Investing in tangible assets like real estate, commodities, and precious metals can act as an excellent hedge against inflation. These assets tend to appreciate in value as the cost of goods and services rises. For example, real estate often appreciates over time and commodities like gold and silver are considered safe havens during periods of high inflation.

How can I reduce the impact on my Investments?

Although the impact itself is tricky to manage, you can prepare yourself in advance by using the following strategies

1. Diversification of Investments

Diversifying your investment portfolio across different asset classes can help reduce the risk posed by inflation. Consider spreading your investments across stocks, bonds, real estate, and commodities. Each asset class reacts differently to inflationary pressures, so a diversified portfolio can provide stability.

Inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), are specifically designed to shield investors from rising prices. These bonds adjust their principal and interest payments in line with changes in the Consumer Price Index (CPI), ensuring that your returns keep pace with inflation.

2. Investing in Real Assets

Real asset-based investments, such as owning property or Real Estate Investment Trusts (REITs), have historically performed well during inflationary periods. Investing in commodities like gold and silver also acts as a safeguard. These tangible assets have retained their value over centuries and tend to appreciate when traditional currencies lose purchasing power. They tend to appreciate in value as the cost of goods and services rises.

3. Active Management and Periodic Review

The impact of inflation can vary over the years, so be prepared to adjust your investment strategy accordingly. Periodically review your portfolio to ensure it aligns with your long-term financial goals and adjust expectations a little higher to account for changing inflation rates.

How can I reduce inflation’s impact on my Long Term Savings?

Everyone has certain long-term goals they save up for. Retirement and education/healthcare expenses are the most important as well as the most common ones. It's difficult to hedge these against inflation but the key is to save up in relation to approximate rates and invest in either safe investments or those that can be easily liquidated

• When projecting your retirement needs, factor in a reasonable inflation rate. Financial experts often use an inflation assumption of 2% to 3% annually. Adjust your estimated retirement expenses accordingly to ensure you'll have enough to cover your lifestyle in the future.

• Traditional low-risk investments like savings accounts or long-term certificates of deposit (CDs) might provide safety, but they often can't keep up with inflation. Consider allocating a portion of your retirement portfolio to assets that historically have been inflation-resistant, such as commodities and real estate investment trusts (REITs). These investments have the potential to provide returns that outpace inflation, helping to preserve your purchasing power.

• Understand the historical inflation rates for education and healthcare in your region. These costs can rise significantly faster than the overall inflation rate. Consider saving specifically for these expenses and keeping an emergency fund always on hand

• Explore tax-advantaged accounts like plans for education and Health Savings Accounts (HSAs) for healthcare. These accounts can help you save for these specific needs while providing potential tax benefits.

Conclusion

If you're uncertain about how inflation impacts your current investments or need guidance on adjusting your financial plan, consider consulting a certified financial advisor. They can help tailor a strategy to your specific needs and goals.

You can also go one step further and make an ‘Inflation-resistant budget’ by reviewing your current budget regularly and factoring in rising prices for essential goods and services, like groceries, transportation, and healthcare (following the golden rule of the 2% increase)

Finally, remember that there is no one-size-fits-all solution. Your strategy should be tailored to your specific financial situation, risk tolerance, and investment horizon. Keep yourself informed about economic trends, inflation rates, and government policies that could affect your finances. Knowledge is a powerful tool for making informed decisions.

By: Pratiksha G. Prabhu | Linkedin