Heard the rumblings about inflation lately? It seems the talking heads have found their newest victim. As recent headlines fill with scary tales of inflation, this article takes a closer look at what to make of all the commentary and what you can do about it as an investor. Bottom line: don’t panic. As usual, careful planning remains your best guide.

What Is Inflation?

Inflation is the rate at which your dollar loses its buying power as prices go up. So, let’s say your morning bagel cost $1.00 twenty years ago. If the average inflation rate had been 2% over that twenty year span, that same bagel would now cost you $1.49. Items and services experience different rates of inflation at different times, but generally speaking inflation is usually calculated using the Consumer Price Index (CPI).

Recent headlines have been reporting a sizable increase in inflation, so outlets have been keeping busy with reports of how a 5% May consumer pricing surge was “the biggest 12-month inflation spike since 2008.”

Putting Inflation in Proper Context

Before you start to panic, it’s worth putting things into proper context. We’re comparing May 2021 to pandemic era May 2020, when we were still deep into what The Wall Street Journal called a “screwy” pandemic economy. As the WSJ explained, “If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track” (a lot of performance reporting can also fall in that category).

Another important point to be aware of: Not all inflation is bad. In fact, some inflation is necessary for the economy to grow and for interest rates to be reasonable. While it’s a great time to borrow money (i.e. low mortgage rates), it’s a terrible time to have money sitting around (0.01% interest on your savings sound familiar?). A 2% inflation rate is typically considered normal – it prevents the economy from getting a squeaky wheel.

What if Inflation gets out of hand ?

While inflation has a purpose, it can also be devastating if it gets out of control. If it does, uncertainty goes up and it can wreak havoc on the economy, job markets, and financial markets. (Deflation—the opposite of inflation—can also upset the economy if prices drop too low.)

Investors who were around in the 70’s may clearly remember when it spiked to a 14.8% in 1980. The New York Times described it as an era when “prices of real assets… soared. Average mortgage rates exceeded 17 percent, and interest rates on bank certificates of deposit approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.” While a 12% CD sounds great, if interest and inflation rates are that similar, the real returns from high-interest CDs can essentially become a wash.

After its peak in 1980, the Federal Reserve (the Fed) brought inflation back down and put the guardrails on – essentially hitting snooze on inflation for the past several decades.

What Can You Do About It?

The Fed has suggested that rising rates should wane – and we can hope they’re right. But we also know the future can be unpredictable and any outcome is fair game. What do you do? All things being equal, diversified investing remains a solid strategy.

Explaining Inflation Doesn’t Predict It

While scientists can easily explain why earthquakes occur, their ability to forecast the time, location and severity of an earthquake is murky at best. The same can be said for inflation: we can tell how high or low it is at any given moment, but we can’t predict its future with any type of precision. There are simply too many variables: COVID, political action, the Fed, other central banks, the U.S. dollar, time … and you.

Any one of these could throw off a prediction about the time, magnitude, and extent of future inflation. Besides, as an investor, you really only have control over the last two: you, and your time in the market.

We Don’t Know So We Diversify

Because we don’t know when inflation might go up or down, a solid bet is to diversify into and across various investments that tend to respond differently under different conditions.

As an example (and not a solicitation), until earlier this year, value stocks had been underperforming growth stocks for quite some time. You may have been tempted to give up on them during their lull (during which inflation remained relatively low). But surprise surprise, when inflation is high or rising, value stocks tend to outperform growth.

Another example is TIPS (Treasury Inflation-Protected Securities) versus traditional Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across different inflationary environments.

Stocks vs. Inflation

If you have the time to stick it out , stocks can be your greatest ally against inflation. Over time, global stock market returns have dramatically outpaced inflation. For example, as reported by DFA, $1 invested in the S&P 500 Index from 1926–2017 would have grown to $533 by the end of 2017. Had that same dollar been held in “safe” one-month Treasury bills over the same period, it would have grown to a whopping $1.51. As long as you have enough time to let your stock allocations ride through the downturns, you can expect them to remain well ahead of inflation simply by being in the market.

What If You’re Retired?

What if you don’t have the luxury of time and you’re depending on your portfolio to provide income? Focus on what you can control and engage in retirement planning. A few items to think of:

  • Asset Location: Among your taxable and tax-deferred accounts, where will you put your stocks, bonds, and other assets for efficiently accumulating and spending your wealth?
  • Spending: How much can you safely withdraw from your investment portfolio to supplement your other income sources (such as Social Security)?
  • Withdrawal Strategies: Which accounts will you tap first, second, third?
  • Don’t Panic: Don’t exchange quality for junk – a common mistake many investors make when searching for income.
  • Have a back up plan: You may need to revisit your goals, spend less or work more. While these choices are never fun, they are often preferred over chasing returns that could make things worse.

How Can We Help?

While anyone can embrace the strategies I just described, for others it can be easier said than done. Plus, there are more steps you can take to defend against inflation. Examples include engaging in additional tax-planning, tapping lines of credit like a second mortgage, optimizing Social Security benefits, and more.

Have questions? Schedule some time to discuss these and other retirement planning items worth exploring. After all, making the most of your possibilities is always a smart move, whether or not inflation is here to stay.