Take Cautionary Steps to Navigate the Current Inflation Spiral

We're in the midst of an inflation SPIRAL. Is it momentary - a short-term affair resulting from pent-up COVID 19-created demand and those darn supply chain problems? Or will it hang around for a while? NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Desperately Seeking Answers

What's the answer? Who the heck knows. Maybe it’s transitory…maybe it’s not. It’s looking more and more like the latter, but we don’t yet know for certain one way or the other. So, maybe we play it safe and prepare for a longer spell of higher inflation than the Fed Governors, the Treasury, and the Wall Street smart money has led us to believe.

One thing is not up for debate - prices are rising and our purchasing power is not. For that reason, it makes sense to factor inflation into your retirement planning. In an enduring period of significant inflation, one can't overestimate the reassurance of a balanced portfolio…one that fits you and the current rate of inflation.

Revisiting the Rule of 72

In a past blog, I talked about the “Rule of 72", and how it might be a handy tool for quickly comparing investment opportunities. A recap: The Rule of 72 is an old-fashioned rule-of-thumb tool you can use to calculate how long it will take to double your investment money, given a certain interest rate.

An example:

If you are earning 5% on a $5,000 investment (72/5 = 14.4) you will double your money about every 14 years. After 42 years, your investment would double in value approximately three times: $10,000 after 14 years; $20,000 after 28 years; and $40,000 after 42 years. A more precise calculation using a compound interest calculator would show a value of $40,303 after 42 years, compounded quarterly. Either way - that’s the kind of math that impressed Einstein and Franklin…and should impress any young saver. It demonstrates the importance of tucking money into IRAs and/or 401(k)s early in life to reap the full benefit of compounding.

By the way, that same Rule of 72 can be used another way…to spot a potentially risky investment. Suppose Shyster Sam offers you an “opportunity” to double your money in three years. Divide that three-year promise into 72 (72/3=24%), which suggests that Sam is willing to pay you 24% on your investment. It may be real, but it’s more likely a scam. Twenty-four percent yields aren’t common.

Conversely, the Rule of 72 can be useful in determining the debilitating effects of a core annual inflation rate…say 5.5%...over time to determine how many years it would take to slash an individual’s purchasing power in half (72/5.5 = 13.1 years). Even that 2% core inflation rate the Fed claims we’ve enjoyed in recent years was effectively slashing our purchasing power in half (72/2) every 36 years – roughly the amount of time many folks spend in the workforce. That’s right, even “low” inflation takes its relentless toll.

Cautionary Steps

Now is no time to think only in terms of those dollar figures printed on your paycheck. What they’ll buy today won’t be what they’ll buy tomorrow.

The value of that new home you may end up purchasing will tend to increase in value with inflation (keeping you somewhat whole), but it might prove helpful to finance it with a fixed-rate mortgage. Why? When you “fix” your monthly mortgage payment, a higher inflation rate helps you build equity faster by stabilizing your borrowing cost.

And speaking of homes, it wouldn’t hurt to review your insurance coverage. Replacement cost insurance, though more expensive, will enable you to replace items you lose as the result of a catastrophe at full value after prolonged inflation, and after the inevitable increase in construction costs. Inflation dictates that a home will cost more to rebuild after a catastrophe, due to rising costs of materials and labor; thus, replacement cost coverage is based on current costs, rather than the original cost to build a home.

Also, now is the time to be cautious about how you view investing for retirement. In general, many folks tend to be very conservative in investing for retirement (e.g., holding a percentage of bonds equal to one’s age in a retirement portfolio). Perhaps that approach should be adjusted or reconsidered during this inflationary periods - at least for now. Of course, there is no good way to predict the rate of future inflation except to become omniscient. But we do know that the purchasing power of bonds will degrade over time in the presence of inflation – including those future coupon payments.

Take the case of a 30-year-old projecting how much he might need as income in retirement (assuming that 2% inflation number I mentioned earlier). If he’s thinking $75,000 in today’s dollars will do the trick, well, cut it in half because in 36 years (72/2), the purchasing power of that $75,000 will erode to $37,500…and that’s on “day one” of retirement. Most people are living longer, often 15-20 years longer in retirement, which means purchasing power erosion will likely continue during those golden years, as well.

Gentle Reminders

If nothing else, this current burst of inflation is a gentle reminder of the importance of taking spending power erosion into account in your financial planning. In short, act now, not when you start incurring the pain of rising prices later on. By then, it might be too late to take corrective action.

Stocks serve as your portfolio’s growth mechanism in most market environments – but not always. Stock valuations have risen over the long haul, but certainly not in a straight line. Since 1950, the S&P 500 has experienced 36 double-digit corrections…one every other year or so on average. Recall the 56% pullback in 2007-2009 and the more recent rapid 34% correction in February-March of 2020…one brief and the other quite lengthy. In those and other corrections, bonds helped investors minimize losses, providing certain comfort to folks with balanced portfolios.

Simply stated, a properly balanced portfolio helps you navigate whatever challenges the market offers. Easier said than done, of course. But remember, the expectations of bond investors matter to the Federal Reserve who carefully watch for bond market signals. It helps them decide when to raise interest rates to put the brakes on inflation – an action that often negatively impacts stock prices.

Watching interest rate activity can help you, too, in rebalancing your portfolio.