Inflation: It's Back
For the last 20 years, inflation has been like the monster under your kid’s bed. We have consistently feared it, but every time we look, nothing is there. Well, something is finally under the bed, and it is pretty scary.
If you have made any purchases in 2021, you have noticed prices rising. It is happening in the grocery store, the hardware store, and at the gas pump. If you have sold or bought a house this year, your head is probably still spinning. High inflation is not good for maintaining a stable economy or for your pocketbook.
While it may be concerning to see prices rising, it is our opinion that this is a short-term trend caused by supply chain disruptions and pent-up demand. There is no doubt that the U.S. Government has infused an unprecedented and record amount of financial, both fiscal and monetary, stimulus into the economy. However, there is little evidence that money supply alone leads to inflation (don’t get mad at me, get mad at the data!). The velocity of money is what matters, and it is still very low by historical norms. Velocity of money supply measures how quickly dollars are moving through the system, which is different than the total dollar supply.
If you read any of our content, you know that making a plan based on predicting the future will end poorly. We don’t know for sure how long the current inflation trend will last, or how bad it will get. But we still should consider inflation as a threat to our investments and take actions to protect against it. Below are 3 important ways to protect your assets from inflation.
1) Maintain Equity Exposure: All too often we see investors get way too conservative, way too quickly as they approach retirement. Having most of your money in cash and bonds may have worked in the 80s when interest rates were nearly 20%, but in today’s low interest environment most bonds are nearly guaranteed to return less than inflation over the next 5 years. Today, it is extremely important you maintain enough exposure to the stock market, even while you are retired. By investing in the stock market, you have a small ownership in thousands of companies who can raise prices as inflation rises. The correlation is never 1:1, and there are periods of time when inflation is high and the stock market is down (stagflation); however, over the long term, equities have returned more than the rise in prices. So how much of your portfolio should be in equities? That will come down to your individual plan, but we feel that AT LEAST 50% of your liquid portfolio should be invested in the stock market (vs. Bonds and Cash) and if you have a time horizon longer than 5 years you should strongly consider being 100% invested in the stock market.
2) Own Different Asset Classes: Not all investments respond to inflation the same way. Real Estate and Commodities do a great job of keeping up with unexpected inflation. Even within bonds there are Treasury Inflation Protected Securities (TIPS) that have an interest rate tied to inflation. Unexpected events, like inflation, are precisely why you should not invest in only one asset class. In 1979, when the CPI increased 13%, Real Estate appreciated 70%! Past performance does not guarantee future success, but you can see why it makes sense to own more than just the S&P 500. The right allocation will depend on a lot of factors, but we never recommend “making bets” in your portfolio. You need a healthy allocation to multiple areas, like Real Estate, that will perform well during periods of high inflation, but you should never own more than what makes sense for periods of low AND high inflation.
3) Watch Your Cash Levels: Cash serves an important purpose in your financial plan. It is the equivalent of portfolio insurance. Whenever your car breaks down, you have a medical event, or the stock market drops cash will save you. Cash can save you not only practically, because you have the cash to cover an expense, but also emotionally because you will be able to withstand the volatility of the market. But right now, it is expensive insurance. Very expensive insurance. You are guaranteed to be losing purchasing power by keeping cash in your bank. Like any insurance, you should only have as much as you need and not a penny more. The right amount will depend on a lot of factors, but if you have more than 3 months of livings expenses saved in cash, then it is time to start thinking about other options. If you can’t quite stomach putting your entire cash hoard into the market, we think a great baby step is buying I Bonds. The max you can purchase is $10,000 a year, but they are currently yielding 3.54%. These are not “cash equivalents,” so please don’t put your emergency fund in I Bonds. But if your cash is building up, I bonds are a good first place to look for a little extra return. You must hold I Bonds for 5 years to get the full yield, but even if you held for just one year you would earn 2.65% based on the current yield. Lastly, watch your bank account like a hawk. Don’t let cash accumulate. Put an auto-deposit in place to move money out into your brokerage account each month. Being disciplined and staying invested is the best way to beat inflation.
Lastly, no one variable affects your plan in isolation. If you increase exposure to equities to offset some inflation risk, you also now increase your market risk. No decision is in a vacuum. Just like the butterfly effect, one decision has ripple effects across your entire portfolio. Ultimately, you need a comprehensive investment and financial plan that incorporates all known variables into a cohesive strategy. If you don’t yet have an plan in place, it is never too late to start and we would love to help.