The Real Risk of Inflation and How to Mitigate It

inflation risk in your portfolio

Question:  I am retired and most of my savings are in money market funds, which earn next to nothing.  Prices of food seem to keep going up, and rents and housing prices seem higher than ever.  I know gas prices are currently lower than in the recent past, and I keep hearing that inflation is under control.  How should I allocate my investments to protect me against inflation risk?

Answer:  The “headline” inflation figures you hear on TV or read in the newspaper are based on the Consumer Price Index (CPI), a national average that tracks the costs of goods and services typically purchased by consumers across the country.  As of May 1st, the CPI was up only 0.9% over the past year, which is well below the 3.0% average inflation rate over the past 80 years.  “Core” inflation, which is the CPI less the increase in the costs of food and energy, rose 2.20%, significantly more.  Price increases in the short term are usually small, so we don’t notice much.   But changes over longer periods of time are very noticeable.

For example, a loaf of bread that cost $1.68 in 2008 sold for $1.98 at the end of 2015, and over that same period of time the price of one pound of potatoes rose from 32 cents to 78 cents. Average rents in the country in 2008 were $800.  Today they are $1,314.

Increasing costs will dampen anyone’s lifestyle if their income doesn’t keep up.  Using the 3% historical average annual rate of inflation to project forward, an income of $1,000.00 per month today will only buy $633.00 worth of stuff in 15 years.

Inflation can be devastating on you if you are retired and living on a fixed income.  Medical expenses and rents tend to outpace inflation.  Older people tend to invest conservatively, a natural tendency because they know that if they lose their money they won’t be able to get it back.  So they tend to allocate their portfolio to bonds, CDs, and cash with little, if any, exposure to stocks.  They mistakenly think they are avoiding risk, but they are wrong because they are neglecting the risk of losing purchasing power.  They are afraid to own stocks even though history shows that stocks provide significant growth over inflation.

Over the past 80 years, stocks and bonds have returned on average around 11% and 4%, respectively. Using a 4% rate of return on an income portfolio as an example, it is easy to see how a retiree can lose ground over time.  After inflation and taxes, there isn’t much income left for living expenses, so he or she is forced to live off of principal.  When you spend principal you engage in a downward spiral that you can’t recover from, and if you live long enough you will run out of money, all the while trying to make do with less. 

A proper sprinkling of stocks in your investment portfolio can increase your long-term chance of survival in your fight against inflation.  With proper allocation and planning, you can reduce the long-term risks inherent in the volatility of stocks and lower, or even eliminate, the risk of losing purchasing power.

 

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.