Inflation is making headlines these days. In the most recent report, inflation measured by the CPI (consumer price index) rose to 5.4% for the previous 12 months. What exactly does that mean?
First, to put the number in context, inflation has averaged close to 3% going back to 1926 and has been closer to 2% in the last ten years 1. The 5.4% we’re seeing now is a 13-year high 2. In fact, you may have noticed this yourself, as you’ve seen prices rise more quickly for things that you’re buying, such as gas, food, and housing.
High inflation has been called the “hidden tax”—it has the unwanted effect of reducing spending power. You may be asking: “will higher inflation persist over the long-term or will it go away soon?”
At Castlepoint, we often talk about how the first goal to a successful retirement should always be ensuring your money outlives you. So, as part of that goal, it’s important (and normal) to expect inflation to rise at least little bit each year. Naturally, inflation, or as we prefer to describe it, loss of purchasing power, is a key component to factor into your planning.
A simple way to understand how inflation impacts us is to look at the rising price of a first-class postage stamp. Just thirty years ago, a time when the first George Bush was president, you could buy a stamp for $0.29. Today you’d pay $0.55 instead 3. The rising cost of stamps correlates well with the overall rising cost of goods and services as the CPI has gone from 136.2 in 1991 to $217.7 in 2021 4. In other words, a retiree would have needed to almost double their investment income just to keep up with rising inflation.
If you are retired or plan to retire someday, we have good news: you may be in retirement for a very long time. In fact, life expectancy has been steadily increasing for several years. That means we need to invest your money in a way that both funds future spending and outstrips loss of purchasing power over time.
Evidently, you should be worried about inflation, but not because it has jumped recently. Instead, the focus should be on how you can offset future inflation that may derail achieving future financial goals in the years ahead.
So, what can we as investors do about it? Investing in stocks is a great tool. When inflation causes costs to rise, companies typically pass some of their cost increases on to customers by raising prices. That helps the company earn more money, which increases the value of their stock. So, if you own stocks, some of that inflation you experience as a customer paying higher prices will flow back to you as a stock owner experiencing investment gains.
The data backs this up: stocks have historically been the best asset over the long haul to outpace inflation. Since 1926, stocks have produced a 10% compound return before inflation. If we subtract inflation from the return, stocks have still compounded about 7% over the same time 5.
Although the evidence is clear that stocks are a great way to fight off future inflation in the long run, that isn’t always true in the short run. In the short run, lots of things besides inflation can push stock prices up, or down.
For instance, between 2000 and 2009, the S&P 500 index performed badly, delivering a -2.5% return before inflation. If we subtract inflation, the S&P 500 index had a -4.9% return. Fortunately, this is where patience and discipline paid off for the investor. From 2010 through 2019, the S&P performed very well, delivering a 13.3% return before inflation and a 11.3% return after inflation 6.
That’s a lot about stocks. What about how other assets hold up against inflation?
Cash does not do well during times of rising inflation. In fact, that insight comes pretty close to being a good way to define inflation: cash buys less stuff (is worth less) than in the past.
Bonds don’t tend to do well during times of rising inflation either. While prices go up, the income from bonds remains fixed. So why do we hold bonds? Our job is to help you live an abundant life, and that involves more than just fighting inflation. Bonds—short-term, high quality bonds in particular–play an important role in your portfolio, especially when it comes money that is needed in the next few years.
At Castlepoint, our focus is on ensuring your portfolio is positioned to harness positive real returns in the current inflationary environment and all future environments. Again, we have found that diversifying across global stocks has been the superior way to generate positive real returns over the long run. Additionally, we layer in REITs (real estate investment trusts) and TIPs (treasury inflation protected securities) for some clients to hedge against shorter-term unexpected inflationary shocks.
On your end, we recommend ignoring the financial headlines. We also disagree that so called “portfolio hedges” such as gold, are the best way to invest for long-term success. The bottom line is no one can predict the future well. We agree with Warren Buffett, who was quoted as saying, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future”7. In an uncertain world, we fully expect holding a well-diversified stock portfolio and enough short-term, high-quality bonds for needs in the next few years will prove to be the best way to grow and preserve real wealth over time.
Sources:
- https://www.in2013dollars.com/us/inflation/1926#:~:text=The%201926%20inflation%20rate%20was,power%20to%20%24105.39%20next%20year.
- https://www.bls.gov/cpi/
- https://about.usps.com/who-we-are/postal-history/domestic-letter-rates-since-1863.htm
- https://www.bls.gov/cpi/
- https://www.officialdata.org/us/stocks/s-p-500/1926
- https://www.officialdata.org/us/stocks/s-p-500/1926
- https://quotefancy.com/quote/115037/Warren-Buffett-Forecasts-may-tell-you-a-great-deal-about-the-forecaster-they-tell-you#:~:text=Warren%20Buffett%20Quote%3A%20%E2%80%9CForecasts%20may,you%20nothing%20about%20the%20future.%E2%80%9D
Other resources on inflation you may find worth reading:
https://www.dimensional.com/us-en/insights/are-concerns-about-inflation-inflated
https://www.dimensional.com/us-en/insights/inflation-an-exchange-between-eugene-fama-and-david-booth
