Should you be worried about inflation right now? The word on the street is no, given the current economic climate. If anything, concerns lean the other way: toward deflation. Still, experienced investors know that they can’t ignore inflation—even moderate annual changes can have a big impact over time. While the blue line here shows how mild inflation has been in recent years, the red line shows how even a small degree of inflation can affect the cost of living. Prices have more than tripled since 1980. That may not be a big deal if your wages have kept pace with price increases, but for people in retirement, inflation can be a major concern.
What something is worth today is called its nominal value. Its future value, adjusted for inflation, is referred to as its real value. According to research published in The Quarterly Journal of Economics, we are prone to think of our portfolios in nominal rather than real terms. Behavioral finance experts call this mistake the “money illusion.”
The money illusion can be especially dangerous to your retirement. “It’s very important to be aware of how even a modest rate of inflation will affect you,” says Kathy Jones, fixed income strategist at the Schwab Center for Financial Research.
As long as prices rise, no matter how small the increase, that’s inflation. When the pace of inflation is slowing, that’s disinflation. And when prices actually fall, that is deflation. As we’ll see with the next slide, deflation is not something to root for.
It may seem counterintuitive at first to think that falling prices—deflation—would be a problem. After all, wouldn’t it be nice to pay less for goods and services and have more money to save and invest? Not necessarily. When prices are falling, consumers and businesses generally aren’t in a rush to buy anything. So while you may think that not having inflation taking a bite out of your investment portfolio is good news, it would likely mean that our economy is not growing at a healthy pace—and that can be an equally big problem.
Japan is a notorious example of deflation. During the past 15 years, persistent deflation has made it hard for Japan’s economy to grow. Deflation’s impact on the economy has affected investors as well. From 1998 to 2013 the Nikkei 225, an index of Japanese stocks, grew less than 9%.
So what’s a “good” amount of inflation? The Federal Reserve has set 2% as its ideal “target” rate of inflation. At that level, prices would be rising steadily enough to encourage consumers and businesses to spend, but the pace of inflation would not be destabilizing.
Ever since the financial crisis, the annual rate of inflation has generally been below 2%. Because this falls below the long-term average of 3%, a new term has sprung up for our current situation: lowflation. “We don’t see a lot of inflation on the near-term horizon, but it’s reasonable to plan for at least a 2% rate, since that’s the Fed’s target,” says Kathy.
- Keep investing in stocks. Over time, stocks have historically delivered the highest inflation-adjusted returns. If you want your retirement assets to maintain their purchasing power through the years, retaining some exposure to stocks may help boost your net real returns.
- Consider dividend-paying stocks with the capacity for paying increased dividends. If the dividend payout increases at an annual rate higher than inflation, your income payout can be an inflation hedge.
- Add Treasury Inflation Protected Securities (TIPS) to your bond portfolio. The coupon rate on TIPS is fixed, but the principal value is adjusted to keep pace with inflation—so coupon amounts fluctuate along with inflation as well. Thus, not only are your interest payments protected against inflation but so is the bond’s value.
- Build a bond ladder. When inflation rises, it typically means bond interest rates are also rising. If you build a bond ladder—a portfolio of individual bonds with staggered maturities (say, every year or so)—it will still be susceptible to price declines as interest rates rise, but at least you can reinvest your maturing bonds at higher rates.