We heard a lot about inflation in 2020, partly out of the concern of some in the financial world who predicted inflation might increase sharply following the COVID-19-related government stimulus. But is it really a risk, and how might impact your investments?
For many, inflation is a dirty word. For some, it conjures images of long lines of drivers waiting to fill their cars with gas in the 1970s. For others, it spikes fear that the prices of goods and services will increase faster than wages.
Why Does Inflation Matter?
Inflation has been lower than the Federal Reserve targets since 2012, which may sound nothing but positive. Turns out, though, that a little inflation can actually be a good thing.
In fact, both the Fed and economists have been concerned about too little inflation, not too much. A modicum of inflation gives the Federal Reserve more options during an economic downturn, because it gives them more leeway to cut interest rates, which can encourage businesses and consumers to up their spending.
The unprecedented amount of government stimulus spending entering the United States economy in the past several months has some worried that it will lead to inflation, but so far, that hasn’t happened. However, the full effects of that spending still remain to be seen.
That said, it’s important no matter the current economic context to understand that inflation risk (also called inflationary risk) is not the risk that there will be rising inflation. Inflation is a fact of the economy and of investing. Instead, inflation risk is the risk that inflation will be higher than expected.
Inflation Risk & Your Portfolio
When it comes to your investments — and in particular if you’re living on a fixed income in retirement — what can you expect in the case of higher inflation? The effects of inflation are essentially that money loses value, or purchasing power, over time. This means that an investor could earn lower real returns (nominal return minus inflation) than initially anticipated.
There are certain investments that are more prone to inflation risk than others, namely fixed-income securities or fixed-rate bonds. When you invest in bonds, you receive a fixed coupon rate (the term for the interest rate that you’ll receive) that never increases, regardless of inflation. Anytime inflation rates increase above the coupon rate for long-term bonds, investors stand to lose.
Let’s look at an example: Say you purchase a 30-year bond today that pays a 3% interest rate, but inflation jumps to 12%. This equates to a loss of your purchasing power over time.
Investments With Built-In Protection
Despite much of the noise to the contrary, inflation isn’t a concern at the moment. But you should still consider it when looking at your overall investment strategy.
One investment type that hedges against inflation and helps provide a balance is Treasury inflation protected securities, or TIPS. Stocks, as well, have historically outperformed inflation over the long haul. Other investments that may be promoted as inflation-protected include commodities and precious metals. While this is often true, these investments may not be as reliable. All these investments have their own associated risks. (Talk to your Wealth Advisor to determine what inflation-protected investments may be best for you.)
As with everything else involved in investing, you should try and mitigate inflation risk. There’s zero way to hedge 100 percent against inflation risk (or any risk, for that matter), so having a mix of investments in your portfolio can mitigate any potential downside risk.
Getting Help to Mitigate Potential Risk
This is where a relationship with a trusted Wealth Advisor will be invaluable to you. They can help you prepare a solid financial plan based on your financial picture, long-term goals, and willingness and ability to take risk. From there, they’ll work with you to develop a balanced portfolio that will help you achieve your wealth management goals.
Beyond those very specific deliverables, a good wealth manager can help you sort through all the rumors and headlines out there, and will have the exact knowledge and expertise you need to provide guidance and clarity, all within the context of your plan.
What concerns do you have about the economy and your investments in the New Year? Ironwood Wealth Management is here to help set you up for investment and financial planning success, with our disciplined principles of portfolio management. Contact us today.