The Impact of Inflation on Long-Term Investing & Planning
Throughout history, inflation has been a constant economic force operating in the background. We may not think much of it from day to day, but over time it certainly leaves its mark on our lives and our financial well-being. Even though inflation is certainly nothing new, it is often misunderstood, and commonly underestimated. Knowing what it is, and how it works, can be crucial to crafting your long-term financial plans. To that end, we’ll provide some insights that will help gain a better understanding of inflation and how to manage its effects.
HighPoint Advisors, LLC helps individuals and families build comprehensive financial plans designed to address the long-term impact of inflation on their wealth, income, and purchasing power. Located in East Syracuse, New York and serving clients throughout the Central New York region as well as many other cities across the country, our firm provides professional guidance across key areas of financial planning. Our advisors work closely with clients to develop personalized strategies that proactively account for rising costs, helping ensure that portfolios are positioned to keep pace with inflation while aligning day-to-day financial decisions with broader life goals and maintaining long-term financial stability.
What is Inflation?
Simply stated, inflation is the rate at which the general level of prices for goods and services in the economy rises over time. What that means in plain English is that as prices for things rise over time, your dollars will buy less of those things (compared to what those dollars will buy today). In other words, inflation reduces your purchasing power over time. This slow grind effect will erode how far your income will go in the future, which is why investments and financial plans need to account for growth that at least keeps pace with the rate of inflation.
Where does Inflation Come From?
There’s no one single measurement that captures the rate of inflation with complete accuracy, but the most commonly cited indices are the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index. These indexes serve to track a wide basket of goods and services that consumers pay on an ongoing basis.
There are a number of factors that make up the rate of inflation:
- Demand-Pull factors: When demand for goods and services exceeds supply, prices gradually rise. This occurs most commonly when the economy is strong and growing.
- Cost-Push factors: When costs for labor, materials, transportation, etc. rise, businesses will often have to react by raising the prices they charge to consumers.
- Monetary factors: An increase in the Money Supply, low interest rates, excessive government spending, and central bank policy can all lead to inflation in the economy.
- Supply Chain Disruptions: If geopolitical events or natural disasters cause global supply chains to stop flowing, then prices may be driven higher.
It’s important to note that inflation in general is typically influenced by a combination of these factors, and not usually the result of a single force at work. That’s why the rate of inflation tends to fluctuate as things change in the global economy.
Purchasing Power Erodes Over Time
Inflation is the quiet killer of poorly designed financial plans. One of its most important effects is that it gradually erodes the power of your dollars. Even a small rate of inflation over time will have a meaningful impact on your investments and your overall financial plan.
Let’s do an example to illustrate the impact of inflation. For this exercise we’ll use a dollar amount of $10,000, a time period of 20 years, and a rate of inflation of 2.5% per year.
- Future Amount Need – to equal today’s $10,000, you would need an amount of $16,400 in 20 years to maintain the same purchasing power.
- Loss in Purchasing Power – $10,000 in 20 years would only be able to buy $6,095 of today’s goods and services. That’s a loss in purchasing power of $3,905!
A point worth mentioning here is that the rate of inflation fluctuates over time. There can be long periods of low inflation, and then some event may cause a sharply higher period of price increases. An example from recent history would be the post-COVID period of high inflation, where the rate of change topped out around 9% in the U.S in June 2022. This was caused in-part by excessive government stimulus, and led to slowing economic growth. As the economy recovered, inflation ultimately settled back into a more normal long-term range of 2-3%. This example illustrates the volatility that inflation can exhibit throughout cycles of the economy.
The Impact on Investments
The way that inflation affects investment portfolios depends on which asset classes are in question.
Cash and cash equivalents don’t stand a chance when it comes to offsetting the impact of inflation. That’s because the meager interest rates that cash accounts pay will quickly lose ground to rising prices over time. Bonds and fixed income investments don’t usually fare much better, unfortunately. The fixed interest payments from bonds lose purchasing power as prices rise in the economy. Stocks do tend to offer inflation protection in the long run, due to the fact that companies can raise prices and grow earnings over time. Inflation can, however, cause short-term volatility for stocks as a result of corporate profit margins being squeezed by higher input costs.
We’ll also point out a few other areas outside of the main asset classes in most portfolios. Commodities and real estate tend to hold up well in times of increased inflation because rising prices tends to increase their underlying values. Additionally, the U.S. Treasury issues inflation-linked bonds that are designed to adjust with changes to inflation, so they will not lose their purchasing power.
So How Do You Plan for Inflation?
The impact of inflation over a long period of time can be felt in many areas of financial and investment planning. From future retirement income planning to individual savings goals like funding a child’s education costs, neglecting to plan for inflation can make achieving your goals seem unreachable. But thankfully there are a number of strategies that will help your plan account for and manage inflation’s effects over time.
The first and most basic thing to do is make sure your plans include an assumption of some amount of inflation going forward, where you’re projecting future costs using a realistic number. Next, you’ll want to ensure that your portfolios are properly diversified into different asset classes. Include some investments for growth, some for stability, some for protection against inflation specifically, when appropriate. For example, growth stocks may provide returns above the rate of inflation, and Treasury inflation-protected bonds can offer price adjustments based on the current and future inflation rates.
Periodic reviews of your plans are crucial to make sure you stay on track. Economic situations change, as does the fluctuating rate of inflation. This can impact basic budgeting as well as income and withdrawal strategies over many years. A nimble and adaptable plan will ensure that goals remain realistic and achievable.
A Winning Formula
Hopefully, you can see why planning to address inflation is a key element of proper investment and financial planning. Maintaining the purchasing power of your wealth over time is very difficult if you don’t account for rising costs of goods and services. While we know that inflation is not a fixed or guaranteed rate of change, it is a constant force that erodes wealth over a long period of years. Without accounting for its effect, inflation can make you feel like you’ll never reach the finish line. This is where a financial advisor can be a valuable resource.
HighPoint Advisors, LLC has many years of experience dealing with how inflation impacts our clients’ wealth. From invested retirement accounts to fixed income sources that clients need to rely on for decades, we work actively to adjust financial plans to changing conditions. Our advisors have the knowledge and flexibility to keep our clients on the right path to work towards their financial goals.
Contact us today to see if your financial roadmap is aligned with real-world conditions.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.