7 Things Investors Should Know About Inflation

Inflation is a particular threat to investors because it comes in many forms. See why even bonds and savings accounts can be at risk due to inflation.
By Richard Barrington

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When investors think about risk, they usually think about market crashes or other examples of investment losses. However, while this might be the investment equivalent of a head-on crash in a car, what can be equally devastating is the type of crash that blindsides you. Inflation is a prime example of a risk that can blindside investors.

After all, thanks to inflation you can make money on your investments and still find your purchasing power slipping away. In terms of long-term planning you might meet all your long-term savings goals because of inflation.And you still not be able to afford the standard of living you expected.

7 things investors must know about inflation

While there is no perfect way to defend against all forms of investment risk, the more you know about inflation, the better you can be prepared for it.

Here are seven things you should know about inflation:

1. Recent years have not been typical

The United States has been living in an extremely low-inflation environment for several years now, to the point where the relative lack of inflation has gone from being seen as a blessing to being a source of concern for some economists. Inflation data from the U.S. Bureau of Labor Statistics goes back just over 100 years, and over that full history the annual inflation rate has averaged 3.3%.

In contrast, over the past 10 calendar years inflation has averaged a full percentage point less, at 2.3%. Recent history even featured the lowest calendar-year inflation rate since the 1950s, at -0.4% in 2009. As a consumer, you may enjoy these low levels of price increases while they last, but don’t get used to them because history suggests they are abnormal.

2. Unexpected inflation is the most damaging

The reason it is especially important not to get lulled into a false sense of security by abnormally low inflation is that inflation does its worst damage when people don’t see it coming. If inflation were running at 5% a year, that would be considered a pretty high rate of inflation but bond yields and savings account rates could adjust, and retirement planners could take this into account. It is when inflation suddenly jumps from next to nothing to 5 percent that bonds would suffer losses, bank rates would likely fall behind inflation, and retirement targets would be caught short.

3. Factor inflation into your retirement assumptions

Speaking of retirement targets, the reason it is so important to accurately account for inflation when setting these targets is that they are so many years in the distance. This gives the compounding effect of inflation more time to take its toll. This means you plan for inflation not only in the years between now and when you expect to retire, but also in the 20 or so years you might spend in retirement.

4. Inflation has been more damaging to investors than bear markets

Think of history’s great bear markets: the 1929 crash, 1987’s Black Monday, and the 2008/2009 financial crisis. In each case, the stock market has recovered to go on to new heights. In contrast, because periods of deflation are relatively rare, inflation almost never gives back any of the value it has eroded from savings.

5. Inflation is especially harmful to bonds

This is where the notion of risk management gets tricky. High-quality bonds are generally thought of as very conservative investments, but they are particularly vulnerable to inflation. Rising inflation forces bond yields higher, and when that happens, bond prices fall.

6. Inflation hedges can be elusive

Given the threat posed by inflation, would you like to hedge against it? Easier said than done. Inflation-indexed bonds offer scant margins over the rate of inflation, so they can help you keep pace but don’t build much real wealth. As for commodities, the trick is picking which commodities are going to drive inflation. If wage pressures are the primary force behind inflation, commodities won’t really help you.

7. Inflation is a good reason to consider working longer

To some degree, wages adjust to inflation over time. This is a good argument in favor of working longer before you retire – keeping wage income coming in gives you some degree of protection against inflation.

Perhaps the most insidious thing about inflation is that it increases the element of unpredictability in retirement planning and investing. When inflation flares up, it tends to be very erratic, so you don’t know quite what to expect. The best advice is to get as far ahead of inflation when it is quiet, because it can make up ground in a hurry once it is roused.

Frequently Asked Questions

Q: Where would be the safest place for my money if inflation goes up: stocks, bonds, or money market accounts?

A: Inflation is a destructive force which fortunately has been fairly benign for nearly thirty years now. However, if you are curious about what might happen if inflation flares up, there is a period of high inflation from the past you can look at as an example.

From the beginning of 1968 through the end of 1981, U.S. inflation averaged 7.6% a year, reaching a high of 13.31% in 1979. Over the course of these fourteen years of high inflation, large-cap stocks averaged just 6% a year, and long-term Treasuries averaged just 3.3% a year. In other words, both lost ground to inflation over this period.

It was short-term T-bills that came closest to hanging in there against inflation during this period, averaged 7.2% a year while inflation averaged 7.6%. You could expect savings accounts or money market accounts to behave most similarly to T-bills, since both represent short-term interest rates.

Some takeaways from this are as follows:

  • “Safe” is a relative term when high inflation strikes. It’s more a matter of limiting damage than coming out ahead.
  • Staying short-term is the best immediate defense. Short-term vehicles like T-bills and money market accounts are at least able to adjust rapidly to changing conditions.
  • Long bonds have the toughest time when inflation rises. This would be especially true now, because bond yields are so low.
  • Stocks and bonds have other strengths. Stocks have had the highest returns when a full range of conditions is considered, and bonds should do very well when inflation is declining.

In short, if you think inflation is going to be rising, you could do much worse than T-bills or money market accounts.

Q: My biggest financial concern is inflation. I think I have enough saved for retirement, but that all depends on prices not rising faster than the value of my investments. How should I invest if I am concerned about retirement?

A: Inflation has been generally tame over the past couple decades, and particularly quiet over the past year, at just 0.2 percent. Still, it is not a good idea to get complacent about inflation remaining mild. A reversal in the direction of oil prices or perhaps a rise of protectionist sentiment in the course of the next presidential election could easily fire inflation back up again.

Inflation should be a consideration in any long-term investment approach, and it is a particular concern in retirement because you no longer have wages that can help your income adapt to the inflation environment.

Savings vs. CDs accounts for retirement accounts

As benign as the inflation threat has been in recent years, this is still a tricky investment environment for defending against inflation. A big reason is because interest rates are so low.

Traditionally, keeping money in short-term liquid vehicles like savings accounts has allowed people to keep pace with inflation reasonably well. The reason is that with interest rates on short-term vehicles able to adjust at any time, if inflation rises, they tend to rise soon afterward.

Unfortunately, Federal Reserve policy has resulted in unusually low short-term rates, so savings accounts have fallen behind inflation. Even though inflation over the past 12 months has been just 0.2 percent, the average savings account rate has been even lower, at 0.06 percent.

Since retirees need to keep some investments in stable and relatively liquid investments, one alternative would be to shop for a long-term CD with a good interest rate and a relatively mild penalty for early withdrawal. The best CD rates are up around 2 percent, which would put you ahead of the recent inflation rate, and as long as the penalty was not too severe, you could cash out of the CD early if rising inflation pushed interest rates higher.

Even once you retire, you should also keep some of your portfolio in stocks as a defense against inflation. Companies may adjust their business strategies to changing inflation trends, so while inflation can be damaging to stocks in the short-term, over the long-term, they are typically able to adapt to it. In particular, if there is an area of inflation that concerns you as far as your retirement expenses are concerned – health care inflation, for example – you could somewhat counteract it by investing in stocks in that sector.

The bottom line is that inflation, investment returns and life span are the big three uncertainties when it comes to retirement planning. Since there is no perfect investment approach to hedging against those uncertainties, the best response is to build in as big a cushion as possible in your retirement assumptions. You can do this by saving more before retirement, and spending less than you think you could afford after retirement.

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Richard Barrington