These have not been ordinary times. Since the onset of the Great Recession of 2008, we’ve been experiencing inflation rates of historically low levels. Low inflation is typically accompanied by stagnant wages which have seemed to be a constant as the economy continues to improve. However, there’s always exposure to expected inflation, and an investor should expect inflation and be prepared.
You may be asking, “What exactly is inflation?” Essentially, inflation is rising prices. But inflation doesn’t affect the product. For instance, the chocolate cake at your favorite bakery isn’t going to be larger or tastier when you buy it for your next party. And the movies you pay for aren’t going to be more entertaining. You see, the basic products will remain the same, but the price of these products and others just rise.
For the first time in a year, the Federal Reserve raised its benchmark interest rate in December and signaled that rates could continue to rise in 2017. (Inflation and interest rates, by the way, are often correlated). Also, the new Trump administration has promised tax cuts and higher spending. These policies, too, may add to inflationary pressures. The Federal Reserve tries to manage the economy with tactics that cause inflation. This is intentional with the long-term inflation target being around 3%. The Fed feels it can keep the economy humming and stave off economic disasters such as a depression by doing so.
Because of longer life spans, retirees need to be insulated against inflation risk. If inflation averages 3% over a thirty-year retirement period, the cost of living may triple for a retiree. And when you’re 80 years old, you certainly don’t want to go back to work to support your lifestyle!
There are certain investment instruments that can help protect you against inflation. Holding a diversified portfolio of stocks and bonds may be one of the better ways. Yes, that type of portfolio will occasionally drop in value; traditionally, bonds have helped make a portfolio less volatile. Now you might be saying to yourself, “I’m older now and stocks are too risky.” But consider the fact that thirty years ago (Jan 01, 1986), the S&P 500 index was priced at 242, and thirty years later (Jan 1 2017), the price of that index is 2,200. Other assets which tend to keep up with inflation are real estate, short-term bonds and precious metals such as gold and silver.
Wise investors also know that inflation is to some assets as termites are to a house. It can eat away quietly at the value of those assets. Often safe investments such as bank CD’s and bonds don’t keep pace with inflation. However, there is one kind of bond that adjusts for inflation: Treasury Inflation-Protected Securities or more commonly referred to as “TIPS”. TIPS, which are U.S. government bonds, are unique because they are guaranteed to keep pace with inflation as defined by the Consumer Price Index (CPI), offering more security. A diversified portfolio of stocks and bonds, such as TIPS, can be volatile but may offer you a better opportunity of increasing the value of your portfolio and outpacing inflation, the silent invader.
In 2017, there’s probably a better chance than ever during these past eight years that we can expected higher inflation and interest rates in the future. So let’s forget the bulls and the bears (I’m referring to markets, of course). Now is the time to start behaving like a squirrel. Really. A squirrel doesn’t put all his nuts in one place but spreads them out. He diversifies his holdings. He knows there’s always some place to look for value (his nuts). With a well-diversified portfolio, you’ll have a place to look whether the markets are up or down. Moreover, you’ll have more likelihood of outpacing inflation.