Spring is finally upon us…well almost. Do you remember your childhood days where the weather was temperate enough that you could walk up to the local drug store (in my case Vallette Rexall Drug) with a dollar in your pocket? In the late 1970s you were able to purchase at least 4 jumbo candy bars with that dollar. Do you wonder why that same dollar today won’t even purchase ½ of a jumbo candy bar? You can point to Inflation risk as the primary culprit in your inability to purchase over 5 times as many calories today.
Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation. Even small increases in the annual inflation rate over a period of years can mean a significant hit to the purchasing power of your nest egg or income stream intended for your retirement.
What are some measures you can take to protect against inflation?
Invest in Asset Classes that are typically an Inflation hedge.
An inflation hedge is an investment with intrinsic value such as commodities (oil, natural gas or gold) or real estate (farmland or commercial real estate). Typically, most hard assets are an excellent inflation hedge; so buy those jumbo sized candy bars and stick them in your freezer 🙂 . In general, commodities/hard assets are negatively correlated to both stocks and bonds. In other words, when stocks and bonds decline, commodities tend to appreciate.
Given its profound impact, inflation has to be addressed by any long-term investment portfolio. While there are no perfect hedges against inflation, there are some rational investment responses to inflation concerns:
- A long-term perspective is critical. In the short-run, no asset class is a perfect inflation hedge, but because the effects of inflation are most devastating on a cumulative basis, long-term returns matter most.
- Stocks play a crucial role. While stocks may be more subject than other asset classes to loss of principal, they can help a portfolio combat the effects of inflation. This is not simply because they offer the highest returns over time. Fundamentally, stocks represent businesses that are actively adjusting to prevailing conditions, so the earnings stream of a well-diversified portfolio can adapt over time to the inflationary environment.
- Bonds are most sensitive to high inflation. In some respects, a U.S. government bond may seem like an iron-clad investment, but while its principal and interest are guaranteed, the future purchasing power of that principal and interest can be significantly reduced by inflation.
The above are general observations, but as always, specific market conditions can change the equation. For example, when stocks are highly overvalued, their future returns (and thus their inflation-fighting power) are likely to be diminished. Conversely, because bonds tend to fall in price in response to signs of inflation, their yields may rise to the point at which they represent an attractive premium over inflation. Therefore, investors should target long-term portfolio weightings according to the long-term trends described above, but should also be alert to market extremes which can skew those trends.
Read about this risk along with many others in our FREE Retirement Report.