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Inflation Risk

How to Manage Inflation Risk

My grandfather gave piano lessons in Shanghai during WWII. He loved lemons. Food prices often increased daily, so whenever a student paid for a lesson, he would rush to the market to buy what he could and hoped there would be enough for a lemon.

Inflation matters when what we want to buy has increased in price in relation to our assets or income. This article helps investors manage inflation risk.

Your inflation is personal

The Consumer Price Index, a well-known measure of inflation, is the change in the prices of a basket of goods and services purchased by an average consumer. It does not measure your inflation rate. We note from our clients’ financial plans that they spend more on travel and services such as health and education than the average U.S. consumer. Services tend to increase in price faster than goods. Prices for manufactured goods have declined through cost savings from automation or outsourcing, while a limited supply of local labor drives the cost of services.

Inflation is personal. My rate of inflation is driven by my spending mix and yours by your mix. Both will change over time as we allocate our spending to a different combination of goods and services. During our earning years, the impact of inflation is mitigated as our employment compensation rises. However, when we transition to drawing upon our financial assets to support our lifestyle, the risk of inflation becomes more evident.

Sources of inflation

We have been fortunate in the U.S. over the past three decades that inflation has not been a concern. Inflation has faded from memory, but some of us still remember the late ‘70s and early ‘80s. 13.5% was the inflation rate for 1980. No one was happy with a ten percent salary increase, and you lost money buying a one-year Treasury Bill at 10.8%.

A variety of factors can drive inflation:

  • Costs pushing up prices: increases may come from raw materials, rents, salaries, taxes, etc. These may be mitigated through increased efficiencies. In competitive sectors, future profits will be diminished when rising costs are not reflected in higher prices.
  • Demand driving up prices: We have all learned from this past year that unanticipated changes in demand relative to supply can produce shortages or price increases. For example, sellers of suburban houses received prices above expectations from buyers looking for more space for remote work. Anyone looking to buy a used car is seeing inflated prices due to reduced supply from rental companies. Often prices driven by demand/supply imbalances will adjust with time as suppliers are motivated to increase supply.
  • Increased money in circulation: The U.S. Federal Reserve has significantly increased the quantity of Dollars since 2008 through multiple “quantitative easing” programs (when the Fed buys bonds, it pays for them by printing money). Many people expected inflation due to this expansion of the money supply. However, higher inflation never materialized because the money created did not circulate through the economy at the same velocity as in the past. No one knows whether this will change. If the money supply starts to circulate faster, prices will rise.

Inflation expectations can lead to higher prices

One of the challenges facing the Federal Reserve is how best to manage inflation expectations. If workers believe that their cost of living will be higher next year and their skills are in short supply, they will demand a raise at least equal to their inflation expectations. If parts suppliers anticipate the cost of replacing inventory will be higher than in the past, they will set prices based on expected replacement costs. If fixed-income investors believe that inflation may depreciate the future value of Dollars, they will demand a higher interest rate, increasing the cost for borrowers. Expectations that push up costs lead to actual price increases over time and creates an inflationary cycle.

Temporary price increases will not put pressure on the Fed to slow the economy by increasing interest rates. However, if the Fed perceives that inflation expectations are creating a new inflationary cycle, they may have to raise rates sooner than planned.

Three steps to limit the impact of future personal inflation

Step 1: Estimate your future mix of spending.

One of the reasons we ask our clients to share their spending goals by category is to apply appropriate inflation rates. College tuitions, health care, and home prices increase at different rates. While we acknowledge that estimates of future inflation are as uncertain as future stock market returns, understanding your future cost of living is the first step in figuring what return is required to meet your goals. This is an important factor in determining your risk level and investment strategy.

Step 2: Determine how much investment risk is required.

To reduce inflation risk, you need to accept investment risk. There are no free lunches. Cash, a low volatile asset, is only safe in the short term. While holding cash protects from a loss of principal, it does not protect from a loss of purchasing power. Given the spending mix of most affluent investors, a material allocation to growth assets is required to “outrun” inflation. The longer your goals are in the future, the more they are susceptible to rising prices, and the more assets you will need to be invested for growth.

Step 3: Select suitable investments.

Research has shown that the best strategies to protect against many long-term inflations are exposure to

  • broadly diversified equity markets,
  • commodities (gold, oil, fresh water, not bitcoins),
  • real estate (diversified, not a property subject to rising water levels) or
  • well-established collectibles (Rembrandts, not non-fungible tokens).

 

Of these, the easiest implementation is a portfolio invested across the publicly traded stock markets around the world. Individual companies may fail to grow revenues faster than costs; the same may be true for specific sectors but not for the global economy.

The other solutions are less attractive. Commodities add a high degree of volatility. Real estate is illiquid. The collectibles market has significant transaction costs. While the U.S. Treasury does issue Inflation Protected Securities (TIPS), their return only matches the Consumer Price Index (“CPI”). TIPS neither generate a return above the CPI nor do they protect if your inflation rate is higher than the CPI.

Don’t lose sleep over short term price changes

Inflation is a risk to achieving your long-term goals. A loss of a couple of percent of purchasing power over one year will not materially change what you hope to achieve. It will over decades. Selecting an equity allocation that matches your long-term goals will have two benefits: current peace of mind and more future spending power.

Lex Zaharoff, CFA

Lex joined HTG in 2014. With over 30 years of experience advising wealthy families at four major private banks, Lex provides clients with a unique perspective on the art and the science of investing to achieve one’s financial goals.

As Adjunct Professor of Finance at NYU’s Stern School of Business, Lex teaches the MBA course on wealth management. He has a BSE from Princeton University and an MBA from Harvard Business School.
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