How to Cope With Inflation as an Investor
Inflation is driving the headlines and wreaking havoc on early and mid-career professionals' budgets. But as a long-term investor, short-term inflation isn't the most significant risk to your financial plan. Your behavior is the most critical risk to your financial plan. Federal Reserve policy and uncertainty are fueling volatility. And volatility in the markets often drives us to make irrational decisions with our money. It is normal to feel concerned. My goal is to help you feel more informed to make educated decisions with your money.
In this blog post, I hope to help you better understand:
The origin of today's inflation
The source of market volatility
How to cope with inflation as an investor
Understanding the Origin of Today's Inflation
Inflation resulted from these four developments:
Federal Reserve actions resulted in low-interest rates and expansionary monetary policy.
Increased stimulus pumped into the economy financed by debt expanded the amount of money floating in the economy.
Disruptions to the supply chain resulted in shortages and more money chasing fewer goods.
A significant drop in the labor force participation rate resulted in a tight labor market and increased wages (although these wage increases are not yet keeping up with inflation).
The chart below illustrates the year-over-year change in the components of inflation measured by the Consumer Price Index (CPI). The May 2022 reading is the highest inflation has been for almost four decades.
The Source of Market Volatility
The central bank is working to balance reducing inflation while keeping the economy out of recession. The Fed is raising the key short-term interest rate to slow economic growth. Increasing rates make money more expensive. When money becomes more costly, interest payments start to eat household and business budgets, reducing available funds for other needs and wants. Higher rates ultimately slow the economy. In theory, this reduces demand for goods and services and thus reduces the rate at which prices increase.
Additionally, the prospect of increasing rates is generating market volatility. Investors hate uncertainty. Markets are forward-looking. Using all known information today, market participants price stocks and bonds based on what they think will likely happen in the future. However, it has grown hard for investors to predict inflation accurately. Investors' expectation of inflation has lagged reported inflation. A mismatch between expectations and reality increases risk and uncertainty, resulting in market volatility.
Fed Chairman Powell, and the Fed governors, work hard to be transparent. Before last week's Department of Labor CPI announcement, investors expected the Fed to continue to raise rates a 0.5% per planned meeting for the next several months. However, the surprise acceleration in inflation (which shows to be broad-based now) has investors guessing if the central bank will take more forceful action to slow the economy by raising rates faster, for longer, or both. Additional steps to reduce inflation will increase the likelihood of the economy slipping into a recession.
The Fed has been doing everything it can to reassure investors. The issue is that the Federal Reserve can't tell the markets in advance exactly how much and when they will raise interest rates because it's a delicate task depending on a lot of ever-changing economic data. Everyone is looking to the Fed. Any surprise developments increase investor anxiety regarding Fed action.
So, as an investor, how do you manage uncertainty? Here are some pointers.
How to Cope With Inflation as an Investor
Despite market volatility, you need to focus on what you control. As investors, we can better manage the following:
Your perspective & expectations
Investors often use tax-advantaged savings to fund educational, retirement, or healthcare goals later in life. Using a tax-advantaged account does more than help you save; it can help you lower your taxable income – and your taxes – in the year you make contributions, regardless of market moves. Here are some considerations:
Consider dollar-cost averaging into your 401(k), IRAs, and taxable accounts. Contributing to tax advantage accounts helps you manage your taxes. Take advantage of tax-loss harvesting strategies when it makes sense for those taxable accounts. Furthermore, dollar-cost averaging into the market using an automatic savings plan helps remove stress from your life.
Consider contributions to 529 plans. Funds grow tax-free, and you may qualify for state tax deductions or credits.
Consider contributions to health savings accounts (HSAs) if you qualify. HSAs are triple-tax advantaged – they reduce your income, grow tax-free, and qualified withdrawals are tax-free.
Are you trying to figure out where best to save your hard-earned money? Download our 18-point checklist, which outlines the accounts you should consider if you want to save more.
A Diversified Portfolio Remains Key
Your portfolio should be inflation resilient. Inflation is likely not ending anytime soon, so constructing a proper portfolio is imperative. Portfolios should primarily consist of broadly diversified, low-cost, index-based securities. The equity portion of your portfolio should have exposure to domestic and international stocks. Maintaining stock exposure is vital, as equities tend to be an excellent inflation hedge in the long run.
Inflation may be outpacing the income generated by the bond portion of your portfolio, but remember that bonds have a role in reducing volatility and portfolio risk. Bonds are struggling this year as interest rates rise, but they generally tend to reduce the overall volatility of your portfolio, which can cushion your portfolio in the long run. Furthermore, the types of bonds you invest in are essential. Quality short-duration bonds help manage risk in an increasing rate environment with increased uncertainty.
Your Perspective & Expectations
This first half of the year has undoubtedly been painful when looking at statement balances. But history tells us market volatility is to be expected. The recovery from this recent correction may not be as quick as in 2020 since the Federal Reserve is no longer supporting the markets. History tends to favor persistence over the long term. If you sell, you turn a paper loss into an actual loss.
The chart below shows the performance of the stock market (bars) and the most significant intra-year decline (dots) each year going back to 1980. The average year sees a stock market drop of -13.5%. However, most years end in positive territory, averaging about 9% gains. Volatility is a normal part of investing, and investors are often rewarded for staying disciplined through short-term volatility.
One way to stay focused is to think about your goals. Your financial plan should incorporate your risk profile. Your risk profile is the balance of:
the growth you need to earn to attain your goals
the amount of volatility you can tolerate
the amount of risk you can afford to take
Your financial plan maps out the investments you need to have high confidence in attaining your goals. If your goals haven't changed, your investment strategy shouldn't either (assuming you have a quality plan).
Uncertainty and volatility aren't comfortable. There's a reason that the index that measures market volatility – the "VIX"– is called the "fear index." But that doesn't mean you have to succumb to it. Take stock of where you are, make informed decisions, update your portfolio where necessary, and monitor your financial plan.
Are you trying to understand how inflation will impact your financial plan? At Pursuit Planning and Investments, LLC, I help you think through your options. I help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your concerns and begin best optimizing your financial plan in that meeting.
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