Inflation Risk – Go Broke Slowly

Inflation risk refers to the problems that investors face when prices rise. In general, prices have tended to rise gradually and continually over time. For the most part, rising prices are barely noticeable – but the effects can be dramatic over long periods of time. Of course, there are also times when prices stay stagnant or even decrease, but for the most part prices have risen throughout history.

An Example of Inflation Risk

You may wonder what all this talk of “rising prices” is about. For a basic example, look at the price of milk. In 1960, a gallon of milk cost $0.49. The Bureau of Labor Statistics shows that in 1995 the cost was $2.47, and the most recent price available is $3.43.What can you get for a nickel?

You might not care that much about milk, but the prices of most other things move in a similar fashion. Perhaps you’ve heard people older than you talk about how much they paid for their first house, for example, and you also will see prices rise over your lifetime.

What’s the Risk?

The fact that prices go up may not seem like such a bad thing. In fact, you may actually want the value of your house to rise because you’ll earn a profit. But you already own your home. There are plenty of other items, such as food, that you’ll need to buy for many years to come. If you’re alive in 20 years, there’s a good chance that you’ll want to buy a loaf of bread at that time.

A problem arises if you don’t have enough money to pay for things in the future. You might have a lot of money saved up right now, possibly even enough to cover your annual expenses 20 times over – but that doesn’t mean you’ll be able to afford anything in 20 years. The prices you’ll pay for most things will rise, and you have to budget for those increases. The longer you live in retirement, the more important inflation becomes. That’s why inflation risk is closely related to longevity risk.

Inflation Risk and Investments

It’s essential to consider inflation if you’re an investor. Inflation risk can cause problems in the short term, as well as over the long term.

For long term investors, it’s fairly easy to see why inflation is important: you’ll be better off if your investments grow faster than the rate of inflation. Unfortunately, you typically have to use riskier investments (investing at least some of your money in the stock markets, for example) to outpace inflation. Conservative investments like bank accounts and bonds may appear to earn money, but you also have to look at your purchasing power: how many gallons of milk can you buy after inflation with the money you invested? If your money isn’t growing in “real” terms (that’s another way to say “after inflation”), you’ve got a problem. Either you need to come up with more money, or you need to try to outpace inflation, or you’ll have to learn to live with less.

Want an example? Let’s say you earn 1.5% per year on your investments. That’s about what you can earn from a CD or a short-term investment-grade bond fund these days, more or less. You might be perfectly happy with that return because you’re using conservative investments, and your risk of losing money is fairly small. But what if prices are rising at 2% or 3% per year? You’re actually losing money. It may not seem like much, but over the course of many years it will certainly add up. If you just keep your short-term money and emergency savings in the bank, that’s fine – it’s the price you pay to have your cash available, and you can’t afford to lose that money. But you need to have a good reason to keep long term money in conservative investments (perhaps that portion of your portfolio is providing diversification and a buffer against market crashes, or perhaps you’re aware of the issue and you just prefer not to take big risks because you are unwilling to lose money).

What about shorter term risks of inflation?

Inflation risk is especially troublesome for people who are heavily invested in fixed-income investments like bonds. Why? There are two reasons, but they’re both kind of the same.

First, interest rates typically rise during periods of inflation. This is partly due to the Fed’s attempts to slow down the economy (when things get overheated, prices rise more quickly than some would hope). When interest rates rise, bond prices tend to fall – especially longer term bonds. As a result, seemingly “safe” investments can take a hit, and that comes as a nasty surprise to many conservative investors.

In addition, bond investors typically receive a “fixed” income. That means their income won’t rise along with inflation, and it won’t keep up with the rising prices of things they want to buy. When your salary stays the same but your cost of living rises, things get unpleasant.

Finally, inflation can potentially be bad news for stocks as it gets harder for companies to keep earning profits. It costs more for them to borrow as rates rise, and their costs for materials and payroll also increase. However, inflation doesn’t affect stocks in nearly the same way as it affects bonds.

Managing Inflation Risk

So, what can you do to protect yourself against the effects of inflation? Perhaps not surprisingly, the best thing to do is diversify and think long term.

Certain types of investments are able to help you manage inflation risk. But the flip side is that you’ll have to expose yourself to market risk. You should never have too much of anything, but having some exposure to inflation-fighting investments is probably a good idea (unless prices start falling…). The most basic of these investments is an investment in the stock market. Yes, it’s true that stock markets can suffer when inflation heats up, but over the long term stocks have tended to outpace inflation. If you’re planning for a long retirement, or if retirement is a long way off, it may make sense to have some exposure to stocks.

Other investments, sometimes called “alternative” investments, may also help. “Real assets” or things that you can own, see, and touch, are typically considered to be good inflation fighters. That includes any real estate or precious metals you own, and indirect investments in those types of assets (mutual funds or ETFs with exposure to real estate or metals). You might also include commodities in this category. As with many things in life, moderation is key, and you don’t want to load up too heavily on any one thing.

Last but not least, Treasury Inflation Protected Securities (TIPS) often come to mind when thinking of inflation. These are bonds issued by the US Government, and the value of your investment adjusts according to inflation. In other words, you’re supposed to be able to take out (in terms of purchasing power) the same value that you put in. But these investments are far from perfect, and losing money with TIPS is very possible.

You should also plan for inflation when you plan for long-term goals. If you’re retiring next year, you might have some idea of what your annual expenses are, but what about your expenses in 10 or 15 years? They’re probably going to be higher, and you need to build that in to your retirement projections (you have done retirement projections, haven’t you?). In other words, you need to give yourself a raise every year in retirement to keep up with rising costs. You might even do several projections, including a “high inflation” scenario, just to see how your savings would be affected. It may turn out that you need to save more money or change your expectations – but it’s better to know that ahead of time than to run out of money.

If you own bonds, be aware of inflation risk. Longer term, high quality bonds tend to suffer the most, so you may want to start reducing exposure to those long before inflation rears its head (don’t try to time it just right). Shorter term bonds, although they pay less, aren’t affected as much. Floating rate bonds, tend to do okay during periods with rising interest rates, but they are riskier than investment-grade bonds for other reasons, so be careful and do your homework.

Can You Avoid Inflation Risk?

It’s hard to imagine how you can completely avoid inflation risk. If you could somehow pre-pay for everything you’ll need in the future, you might pull it off. But, in the case of retirement, that’s simply not possible.

When Will Inflation Come?

That’s another toughie. Very smart people often disagree on this, and timing anything in the economy is just plain difficult. As with most things, it’s best to manage your risk ahead of time – put yourself in a position that you can afford to be in if and when it comes. If it never comes, maybe you can think of your efforts to manage inflation like an insurance policy. Sometimes it’s worth taking precautions.

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