What Is Inflation, Really?
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When I start discussions about investing or financial planning, I find that nearly every client I serve is concerned about the “market crashing” or “losing all their money.” This is called market risk (or systematic risk by some), and for sure it’s a risk and we definitely stress test for it. Some more experienced investors will discuss systemic risk, like what happened with the Lehman Brothers in 2008. And to be sure there many other types of risks the deeper you go.
However, I’ve found that few realize the true impact of inflation risk and how it effects their portfolio performance in the long run, especially my more conservative-moderate clients who are heavily invested in bonds.
What is Inflation?
Let’s start with the term itself. What is “inflation” when it comes not to tires, but to money?… Inflation is an economic force that erodes the value of money over time, resulting in pressures to raise prices. In personal terms, inflation is what makes your money less valuable over time.
“Inflation is what makes your money less valuable over time.”
For example, what you can buy for $100 in 2020 is not the same as what you could buy in 2000, or 1980, and so on. Here’s a common conversation between grandparents and grandchildren: “Back in my day it would only cost 5¢ to go to the theatre!” (when was the last time you used the “¢” character on an English keyboard? Do you even know how to type it without looking?). The grandkid is amazed, imaging what they could do with a $20 bill back in the day. Then as the conversation goes on, the grandparent says: “And my good full-time job payed me a solid $3 an hour.” Oh, I see…
Now, not all types of inflation are equal. This is because there are various ways that the purchasing power of money can change over time within a given economy or sector. Here are three types of inflation that deserve special mention:
1) Stagflation — when inflation continues to increase while economic growth stalls. This term was coined in the mid 1970s when it came to the forefront in the United Kingdom and then elsewhere among developed economies.
2) Hyperinflation — when an unstable economy causes a currency to lose its value due to a lack of trust in a (typically) country’s ability to properly monitor markets. A recent example of this is Venezuela beginning in 2016.
3) Deflation — when prices decrease while purchasing power increases. While this might seem good for individuals of an economy because their money now has more purchasing power, it’s been observed to be a phenomenon of shrinking economies as consumers tend to delay purchases, leading to less cash flow in the market, resulting in slow or negative overall growth. A recent example of this is Greece from about 2013–15.
What Causes Inflation?
The factors that cause inflation can be manifold, but whenever an economy is growing “too fast” inflation tends to come along with it. This is why most consider a “little” bit of inflation to be a good thing.
Now, most economists recognize the following common key factors:
· increased money supply
· increased demand for certain services or products (demand-pull inflation)
· lower interest rates (and general expansionary fiscal policies)
· increased wages (cost-push inflation)
· higher taxes
The key rationale for the establishment of the Bank of Canada, like other central banks, is to curb inflation, which it primarily does by increasing interest rates and restricting the money supply.
How Do You Measure Inflation?
Countries typically determine inflation “rates” every year, and sometimes it’s also calculated for different regions since different local economies inevitably expand or contract in different ways. Nevertheless, what is common is that inflation is measured by a (typically) percentage increase in prices for goods or services during comparable periods of time.
In Canada the most common tracking mechanism is the Consumer Price Index in which 100 is the “baseline” cost such that a CPI of 150 refers to a 50% increase in price.
Now, it’s key to remember that this CPI figure does not include the price of securities like bonds or stocks, or real estate. This is because, as the name indicates, it’s meant to quantify how a typical consumer’s “purchasing power” changes over time. In Canada the rate of annual inflation is typical around 2%.
How does Inflation Affect My Financial Plans?
First of all, never forget that when you look at the future value of your money, inflation causes its value to (typically) erode from year to year. So, if inflation is say, 2% for a given year, and an investment has 2% growth that year, your purchasing power didn’t increase at all. Now, if inflation were, say, 3% that same year, your money’s purchasing power went down, even though the amount of dollars increased!
What does this mean for your long term planning? In most cases, it means you need to invest in assets that are projected to outpace inflation, such as bonds, stocks, real estate, and other business holdings, or possibly more speculative investments. Of course, with more potential for growth comes more volatility (= periods of greater growth and loss). This is why it’s so important to plan for inflation sooner than later since over time the markets will go up (in fact, in a given year there’s a 70% the market will go up), and a longer time horizon will give you a greater ability to recover from any unplanned losses.
If you want a personalized recommendation of what investment decisions make the most sense to achieve your personal financial goals, given the inevitable effects of inflation, consider booking a no risk 30 minute Strategy Session with David J. Sigrist. He and his team can understand your goals, identify your key risks, then provide recommendations, and if so-desired, broker the best solutions for you as he gets international firms to complete for your business.
I hope you found this helpful.
Peace,
David
PS: Hello. Maybe you’re one of those people who don’t really read articles, but rather look at headlines. I get it. We all feel busy. So, here’s a synopsis for you: Inflation is a constant economic pressure that causes the actual value of your money to erode over time. This is why $100 today doesn’t go as far as $100 in 2000. A little bit of inflation tends to indicate a healthy economy, but certain types of inflation can be disastrous. When making long-term financial plans, it’s essential to remind yourself that you need to subtract the inflation from your earnings if you want to actually get an estimate of your purchasing power.
For a limited time I’m offering a 30 minute Strategy Session to help people understand how this reality affects their long-term planning. Book your session with this link, or email me at david.sigrist@ig.ca for more details. Thanks.
