After remaining below 3% for over five years, inflation has steadily increased over the past few months and is now over 5%. This is concerning for many people because inflation measures the value of our money; the amount of goods or services we can get for our dollars. Low inflation means that an item today will cost close to the same as it did last year. High inflation means that the same item will cost significantly more than it did last year.
What Inflation Means for Your Finances
While you need more dollars to buy the same thing when inflation is up, that doesn’t always mean that you are getting more dollars to match the prices. Right now, a high-yield savings account is only paying 0.5% and most other checking and savings accounts pay none or almost no interest. If your money is growing by 0.5% but prices are growing by 5%, then your money is essentially losing value as it sits in your account.
In order to keep pace with inflation and not have your money lose value, it needs to earn a return that is the same or greater than the level of inflation. That is hardly ever possible in a simple bank account, so many people look to their investments instead.
Investment Options to Combat Inflation
There are a number of investments that are popularly seen as ways to combat inflation. We will go through the most common here and discuss their merits as well as their drawbacks. It’s important to remember that, as with all investments, there are unique risk and return implications associated with each alternative. Also, the information here is provided for educational use only and should not be construed as a recommendation to purchase any specific investment. The best investments for you are based on your own unique situation and are best determined by working one-on-one with a financial planner.
Treasury Inflation-Protected Securities (TIPS)
TIPS are US government securities whose principal value adjusts with inflation. When inflation goes up, so does the value of the security. Because of this desirable feature, they pay out at lower interest rates than their non-adjusting counterparts. Research has shown that TIPS do a good job of protecting against inflation over the long term but do not always keep up over the short term, even in 5-year periods.
Gold is a popular investment when uncertainty abounds and has really surged in price over the last couple of years. People like gold because it is a tangible real asset that does not move in tandem with the stock market. While often marketed as a good hedge against inflation, that claim is questionable.
Gold does usually perform well when the stock market is down. However, its lackluster performance when markets are up means that the overall long-term returns for gold actually trail both stocks and bonds. Historically, it served as a good inflation hedge in the 1970s when inflation was at its peak but had negative returns during subsequent periods of milder inflation in the 1980s. During those periods, large-cap stocks outperformed gold by far.
Rising inflation can hurt stock values in the short term. As time goes on, though, the rising costs are passed on to consumers and stocks recover. The stock market has significantly outpaced inflation in the past. Though past performance is no guarantee of future results, we believe it is still an effective way to hedge against inflation and build wealth over time. Growth stocks tend to be more sensitive to interest rates, so value stocks may be better situated to handle inflation.
Bonds pay a fixed interest payment, so inflation makes it so those payments do not buy as much as they originally did. Yet, expectations of inflation get priced into bond markets so that newly issued bonds pay a higher interest rate as inflation rises. Both bonds within mutual funds and individually held bonds can be reinvested at the new, higher rates as they mature.
While bonds may not be the most effective hedge against inflation, they still play an important role in an investment portfolio. Their values fluctuate less so they serve as an important anchor to help balance out the more volatile stock investments in a portfolio.
Global diversification is not an investment vehicle but rather a strategy. Spreading your investments among various countries (and therefore currencies) means that you face different levels of inflation. If one country faces unexpected inflation, your investments in other countries can help to balance out the consequences.
How We Respond to Inflation
There is no doubt that inflation has increased recently. Whether it will continue to climb, stay steady, or drop back down, it is impossible to predict. The future is always uncertain, whether you are considering inflation, interest rates, or even the likelihood of a global pandemic. Because of this, we manage our clients’ portfolios in an evidence-based manner that is designed to withstand anything the economy and markets might throw our way, including inflation. We take a long-term perspective and harness the collective wisdom of the stock market in order to maximize returns at a given investor’s preferred level of risk by investing in a diversified portfolio of low-cost mutual funds.
More important than our investment philosophy, though, is where we place our trust. Even if inflation goes up or the stock market goes down, we know that we are in God’s hands and he is always working for our good. We would encourage you to do the same and remember that though we are financially minded, it is important to stay eternally focused. That is where our true security comes from.
If you would like to discuss how your portfolio is positioned to handle inflation or find out more about how we can help you set up a plan for your finances that reflects eternity, give us a call.
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.