Written By: Nik Aamlid
My children love escalators.
Whereas most parents will bring their kids to the store and be greeted with the question, “Can we buy something?,” our kids ask, “Do they have those sliding stairs?”
Despite our repeated efforts not to allow it, they find it particularly interesting to attempt and climb up the “down escalator.” So far, we have avoided any catastrophes.
As you plan for retirement, factoring in inflation can feel a bit like walking up the down escalator. If you stand still and do nothing, you will indeed move backwards alongside your nest egg’s purchasing power.
If you’re like some of our clients, you may have concerns about looming inflation due to the incoming supply of economic stimulus. Regardless, inflation is an important principle that must be understood and prepared for for anyone looking to grow their wealth.
Let’s unpack the concept of inflation and answer some of the most recent questions our team has received on the topic.
What is inflation?
Inflation can be viewed in two ways: The general rise in prices of goods and services, or the decline in the purchasing power of your dollar over time. These are really two sides of the same coin.
When Grandma or Grandpa recalls the time when “a cup of coffee was only twenty-five cents!” they are referring to inflation.
You will often see economists express inflation in percentage form. The average annual inflation from 1990 through the end of 2018 was 2.46%
What causes inflation?
Inflation is caused by a number of factors, but usually can be traced to an increase in the money supply in an economy. The recent stimulus packages are an excellent example of the ways new money has been introduced into the system with just a few signatures.
There’s a saying, “If money grew on trees, it would be as valuable as leaves.” This visual helps us understand why printing money cannot go on in perpetuity, though it certainly can aid in keeping markets functioning during a downturn.
There’s a saying,“If money grew on trees, it would be as valuable as leaves.”
Earlier, I said the causes of inflation can usually be traced to an increase in the money supply. This can manifest itself in a number of ways, but there are other factors connected to the basic principle of supply and demand.
- Increased demand. When there is an increase in money supply in the system (e.g., the stimulus), this translates to an increase in demand for goods and services. This increase in demand typically leads to an increase in prices if supply remains unmoved.
- Increased production costs. Prices of commodities or raw materials can increase for a number of reasons, often due to supply. Lower supply does not necessarily mean lower demand, however, which sparks competition and drives prices higher. The higher costs of production will then be passed onto the consumer in the purchase of the final product. The recent housing market is a prime example of this. Lumber prices have skyrocketed for homebuilders, which are ultimately felt by the buyer.
- Expectations for inflation. As consumers, we project that inflation will carry on at moderate levels throughout our lifetimes. As such, we demand higher wages to compensate for these increased expenses. As wages increase for businesses, so do prices. In this way, inflation becomes almost a
self-fulfilling prophecy.
That’s great and all, but what do individual investors have to do with inflation matters?
What you should do about inflation.
Let’s go back to our escalator analogy for a minute.
Like we mentioned earlier, you will most certainly move backwards if you stand there and do nothing. (Think, burying your money in a tin can in the backyard. I don’t recommend this for a number of reasons, one of which being that paper money can and will disintegrate over long periods of time!)
Even if you move forward slowly (i.e., ultra-conservative investments), you will still move backwards, albeit at a slower pace.
If you want to make any progress up the escalator, you will need to move upwards faster than the escalator is bringing you downwards. With the Fed having set their target inflation rate at around 2%, your investments will have to earn at minimum 2% annually.
If you want to make any progress up the escalator, you will need to move upwards faster than the escalator is bringing you downwards.
Certain asset classes are better protected against inflation than others, including equities, real estate, and commodities. It’s matters like these where having a certified investment professional on your team can serve your portfolio well if managed properly.
Ultimately, the best thing an individual investor can do to protect themselves against inflation over the long term is to maintain a balanced portfolio. Investments should be diversified enough to withstand the downturns and aggressive enough to prevent the backwards push of inflation.
Conclusion
We’ve just defined and examined the fundamental causes of inflation in the economy.
To help paint the picture as it relates to you, the individual investor, we compared inflation to a downward escalator inhibiting you from reaching the pinnacle. In this visual, the speed of the escalator is analogous to the rate of inflation.
Here’s the deal: You cannot control the speed of the escalator… unless perhaps you become chair of the Fed.
Recent stimulus packages and governmental maneuvers may lead you to worry about rising inflation. We won’t speculate on outcomes in this article, though we have our opinions on where inflation is headed over the near term.
The important matter is that you understand the basic principle of inflation and your role in combating it in your investments.
Do this and you’ll already be ahead of the curve.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
