What is it?
Inflation is the general increase in price level which corresponds to a reduction in purchasing power.
Why do we care about it?
We care about inflation because our dollars buy less. For example, remember when you could buy a gallon of gas for $1? Now it’s $3 a gallon. The same amount of money that would fill our tanks up will only fill up one third of a tank now.
How are investments affected by inflation?
Let’s start with bonds. When a bond is issued, the interest rate reflects the current interest rate environment. If you hold a bond to maturity, then you get your interest payments for the duration of the bond and your original principal back—you do not care about the value of the bond in the interim when your plan is to hold the bond until maturity.
What if you decide you do not want to keep the bond for it’s duration? The interest rate never changes on the bond. If you wanted to sell the bond, then it would have to be for a price that reflects the current interest rate market. For example, if the bond you own has an interest rate of 3% and current new issue bonds are 4%, then the price of your 3% bond will need to drop enough so that the yield on the bond would be the equivalent of 4%. Otherwise, you would be stuck with your bond because no one is going to purchase a 3% bond in a 4% bond market. The same is true if interest rates drop. Your 3% bond is going to be more valuable than a new issue 2% bond, therefore, the price of your bond will increase.
Stocks are better equipped to keep up with inflation because they don’t have a static interest rate associated with their price. Dividend stocks are like the best of both worlds-you are getting dividends that can be reinvested along with the price appreciation.
Real Estate is typically considered a good inflation hedge because the value of real estate still trends up over time. When you have a fixed mortgage rate on your property, your principal and interest do not inflate. If you have a rental property, then the rent you charge will keep up with inflation while your principal and interest payments remain fixed.
Gold has been thought of for many years as an inflation hedge, however, gold is very volatile and has a very inconsistent relationship to the CPI (Consumer Price Index).1
How can it affect our financial plans?
If we don’t account for inflation, then our projections will be way off. For example, if we know we need $1M based on our expenses, we cannot just target the $1M as our goal because by the time we get there, that $1M will not have the same purchasing power in the future. This is why it is important to monitor your financial projections and include inflation factors for expenses.
Financial Journey LLC is a registered investment advisor offering advisory services in the state of Virginia and in other jurisdictions where exempted.Information provided is for educational purposes only and not, in any way, to be considered investment or tax advice.
[…] For some more information on inflation, check out this previous post about inflation. […]