2021 has experienced an increase in inflation to levels not seen in decades. The current Consumer Price Index (CPI-U) trend is over a 5% increase according to the Bureau of Labor Statistics. The last time it topped the 5% mark was 1990.
What does that mean?
Simply put, Inflation is a reduction in what a consumer can buy with money. The same dollar won’t buy as much.
Is inflation bad? That depends on a few variables.
Some level of inflation is generally good for the economy in whole. It helps spur people to buy stuff today, since it will likely cost more tomorrow. The opposite is a problem. If everybody hoards cash, an economic slowdown is likely to follow, eventually causing a vicious cycle. So, some inflation is good.
How does it affect investments? That depends on the investment. For bond investors, it is rarely a good situation (with a few exceptions). Since bonds are loans, the investor receives interest periodically, then their original principal back at the end. If the value of the principal is eroded by inflation, the investor could lose real purchasing power, despite getting their principal back. Lower yielding government-type bonds are particularly exposed to this.
How do we mitigate this risk? Bonds are valuable in a portfolio for their diversification benefits, beyond just their income. At CG Financial, we actively allocate to extended sources of diversification, like commodities, real estate, and alternative investments, in addition to traditional bonds. This reduces our need for government treasuries to offset stock market risks. Also, we allocate to higher yielding segments of the bond markets too.
Does inflation hurt stocks? Inflation is not necessarily good for stocks, but it depends on many other factors. Business borrow money to finance new growth. If the cost of borrowing money goes up, because of inflation, then it hurts the profits of that business, and potentially it’s stock value. However, some types of businesses could be more profitable in an inflationary environment, if it increases their margins or the attractiveness of their products. On balance, stocks can be more inflation-resistant than bonds.
So, what should we do about inflation? Stay diversified.
While stocks have historically beat inflation over long time periods, they can be volatile. Money needed in the next few years is not well suited for stock investments. While inflation is a concern, in the short term, it is unlikely to erode purchasing power dramatically. Over the longer term, inflation is a primary risk to financial goals. Assets not needed for a longer period of time. At CG Financial, we incorporate this into our financial planning and wealth management process, staging money by time period.