Most investors are focused on liquid investments such as stocks, bonds and commodities. Inflation can have a significant impact on each of these investments in slightly different ways. The bottom line, however, is that investors are better off in these investments versus cash in the face of inflation. Holding cash without return in the face of inflation can be a declining investment due to the shrinking buying power of cash. If you have $10,000 in cash today, it may still be worth $10,000 on paper in a few years. However, the basket of goods that $10,000 can buy could be much smaller in the future.
Stocks. Stocks are typically backed by businesses or real estate. If consumers are dealing with inflation, the real estate, goods or services sold by these entities are typically rising in price. If we are purchasing stocks backed by businesses or real estate that are attractive to consumers, these entities will be able to price their goods and services to maintain their profit margins. This means that any price increases they are experiencing are being passed on to consumers. By passing these cost increases on to consumers and maintaining their profit margins we, as stockholders, will enjoy higher revenue and earnings that mirror inflation. Thus, our investments are rising with inflation.
Bonds. Bonds are a little tricker as there are many types of bonds backed by businesses or the U.S. government. Treasury bonds are difficult to own in the face of inflation, as we saw in the first quarter of 2021. Interest rates typically rise during inflation because it is expected the Federal Reserve will increase rates to fight inflationary pressures.
Rising interest rates means decreasing bond prices. When the Federal Reserve raises rates it encourages financial institutions to lend at higher rates, which decreases borrowing, thus decreasing the amount of money supply in the economy. When buying bonds during inflation, it is best to focus on buying government bonds that may be held to maturity, floating rate bonds where the interest rates will fluctuate while prices stay stable and some bonds backed by businesses that may be in a stronger financial position to withstand inflation as described above.
Commodities. Owning commodities can be very attractive during inflation. Commodities such as natural resources typically have a finite supply that cannot be easily increased. Thus, if the buying power of currency decreases but supply stays low, the prices of commodities will rise. By owning the commodity, we profit from these rising prices.
Forbes released an article on July 2, 2021 entitled “Inflation And You: 8 Tips For Your Finances.” Here are the tips they focus on that may be of interest to you.
- Keep the inflation news in context. Inflation numbers can be skewed by the time period they are being compared to. Prices a year ago may have been at very depressed levels, which may make the year-over-year seem overly high. The best comparison is to prices prior to the Covid-19 crises. And, we need to take a serious look at whether currently high prices are sustainable or only a temporary phenomenon.
- Stress-test inflation in your plans. When conducting financial planning it is good to look at a variety of inflationary impacts. If inflation is higher than expected, will your plan still be successful?
- Figure on higher Social Security benefits in the next year. Rising costs can be a concern, especially in retirement. It is important to remember, however, that social security benefits risk each year with inflation. ( JJ. You mean “are at risk”?) This is a nice benefit for retirees who are funding the majority of their retirement from social security.
- Look for opportunities in coming months to grab higher returns on your savings. Savers may be able to cash in on higher rates on low-risk investments like bank savings and CDs.
- Lock in low fixed rates on mortgages and other loans while you can. Look for opportunities to lock in low interest rates while avoiding adjustable-rate loans. Stay diligent not to over extend yourself.
- Avoid long-term bonds. Long-term bonds are subject to greater price decline in the face of rising interest rates.
- Keep investing in stocks for the long term. Historically, stocks grow at a faster rate than inflation over the long-term.
- Keep an eye on what the Federal Reserve does to manage inflation. The Federal Reserve has done a decent job in recent decades of controlling inflation by adjusting interest rates. It will be important to keep an eye on their activity.
Overall, inflation can feel uncomfortable as we start paying more at each grocery store trip or are looking at purchasing items we need. However, as investors, we do not have as much to worry about as we have the power to grow our assets with inflation.