In these uncertain economic times, I often get questions from clients about hyperinflation and whether to be worried about it. While the US has experienced periods of higher inflation in the past (many people remember the ‘70s, when prices went up an average of 7 percent a year), over the past 30 years inflation has stayed quite low. In recent years, the Fed has been injecting a tremendous amount of money into the economy, but I don’t believe that hyperinflation is a major risk right now.
So, end of story, right? Wait a second. Just because you might not have to worry about hyperinflation, it doesn’t mean you shouldn’t be worried. In reality, you really should be worried about regular, run of the mill inflation.
But First, A Disclaimer
Generally speaking, I believe that inflation should be taken into account when putting together your investment strategy. However, it’s important to remember that everyone’s situation is different. If, for example, you’re already retired and comfortably well off, or not concerned about estate planning, you may not need to be concerned about this. As you’re reading, remember that your situation is unique, and seek out the help of a trustworthy advisor if you feel you need advice.
Why You Should Worry
According to the Bureau of Labor Statistics, the long term average inflation rate in the US is 3.22 percent per year. That sounds pretty respectable, considering that there have been periods of higher inflation (like the 1970s) and a period of deflation (like the Great Depression), combined with many periods of low and moderate inflation, most notably in the last 30 years.
This is usually where the conversation about inflation ends. But we often forget to think about the power of compounding, which can make that modest 3.22 percent incredibly scary: At this rate, prices roughly double every 20 years, which means that whatever you’re paying for food, healthcare, and vacations now will require twice as much cash in 20 years! This is especially potent if you’re 20+ years away from retirement, as you have a long time horizon to think about and prepare for.
Let’s put it in perspective: In simple terms, if you need $100,000 a year to live comfortably now, in 20 years you’re going to need about $200,000 just to keep the same standard of living. In 40 years, you’ll need around $400,000.
So, next time you think of keeping all your investment dollars in cash because you’re fearful of investing or because you want to try timing the market, I advise you to reconsider. Not only could you lose out on growth over that period, but you could encounter one of the many pitfalls of timing the market.
Is Your Retirement Planning Keeping Up?
When you take this perspective on inflation, it suddenly makes a lot of sense to invest in asset classes that provide returns comfortably above inflation rates. This also illustrates the high risk you take by keeping your savings all in cash, where you are signing up to lose money over the long term when factoring in current interest rates and future inflation.
In fact, inflation should be one of the single biggest things you think about when you make retirement savings plans, especially if you’re younger. As stated above, if you’re 40 years old and need $100,000 to cover your living expenses, you need to be prepared for the fact that when you’re 80 you’ll need about $400,000. If you don’t put this knowledge into your planning, you can seriously hinder your financial wellbeing and happiness in your later years.
What Do I Do?
There are a couple of key steps you can take to avoid the ravages of inflation.
First and foremost, save! Saving for retirement is critical in this day and age, and you should be maxing out your contributions to your 401(k) or IRA whenever possible. Putting money away today and investing it will give your savings more time to grow, which means that the power of compounding can start working for you, rather than against you. Of course, you should be investing this money in a quality, diversified portfolio.
Next, dust off your retirement accounts, take care of that IRA Rollover if you need to, and see where you’re invested and how things are going. If your long term investment accounts haven’t been keeping up with inflation over a reasonable period of time, it’s a big problem. This type of performance assessment is an important part of managing your savings, and it’s part of the reason I tend to recommend actively managed, well diversified investments to my clients. Active management ensures that your holdings don’t stagnate and diversification allows you to take part in the growth of uncorrelated asset classes, and both can hopefully shield you from big downturns that reduce the long term performance of your account.
Overall, a well managed account will both protect your investment from inflation and possibly provide additional growth that can enhance the value of your savings – so that $400,000 in 40 years won’t seem like such a big deal. However, even if you’re older and have a more conservative allocation, your account should generally still be providing returns above inflation to ensure a consistent lifestyle over your retirement (with the caveat that this might not apply in every situation).
Variety: More Than Just The Spice of Life!
It’s important to note that not all of your money needs to be in one kind of account. In fact, you should be well diversified across different types of investments, both conservative and risky, with an allocation that suits your risk and time profiles. This can mean holding anything from cash, CDs, and money market funds to real estate, corporate bonds, high yield bonds, alternative investments and, of course, equities.
Also, remember that if you invest money you can lose money. But if you diversify, actively manage, and invest over time with a strategy like dollar-cost-averaging, you will likely be in a much better place than you would otherwise. And if you do nothing, history has shown that you will be worse off in years to come. I say take calculated risks that work for your particular situation and risk tolerance.
There is one important sidenote to keep in mind: remember that not all your savings belong in an retirement account. I advise clients to keep a cushion of emergency money, usually about 6 months to one year of living expenses, in cash or a short term account, just in case. It almost never makes sense to pull money out of a retirement account before you retire due to the taxes and fees involved, so do yourself a huge favor and make sure to have easily accessible savings on hand.
Did these inflation numbers shock you? What are you going to do to inflation-proof your investments?
photo credit: Patrick Henson via photopin cc
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Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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