Inflation Risk: The Silent Killer

June 7, 2017 · Written By Thomas D. Wilson, CFP®

Inflation can erode purchasing power, cause volatility in stocks and bonds, devalue interest income of securities, and reduce profit margins of company stock.  Put simply, inflation is an ever-present risk.

Recent predictions by Kiplinger expect inflation to reach 2.5 percent by the end of 2017—a year-over-year increase of 0.4 percent.  As cited by the Consumer Price Index, the average inflation rate has averaged roughly 3 percent since 1914.  At this rate, an investment portfolio’s value is cut in half every 23 years.

The core inflation rate (which does not include food and energy) is also expected to be higher by the end of 2017.  Inflation is increasing largely due to rising energy prices, which has prompted the Federal Reserve to raise interest rates by a quarter percentage point in March and twice again in the remaining months of 2017.

Cash on the Sidelines

Economic and political uncertainty has caused many risk-averse investors across the globe to stockpile cash instead of investing in financial markets.  And it amounts to a substantial chunk of change—approximately $50 trillion dollars is currently living out of the markets, which is more than we’ve seen sidelined since 2008.

What happens with that $50 trillion in cash will influence future market trends. Investors may choose to invest in gold or silver, or they may reinvest in stocks and bonds once the interest rates creep up.  Because we can’t be sure how future markets will react, investors need a strategy to shield themselves from inflation risk.

No Investment is the Worst Investment

Though stockpiling cash may seem temporarily appealing, doing so could result in lasting consequences.  While we expect market downturns to be followed by periods of recovery, deflation (or negative inflation) is quite uncommon. Thus, the effects of inflation are rarely reversed, and continue to penetrate any cash reserves you have…no matter how thick the vault walls.

From 1926 to 2016, inflation in the United States averaged 2.94 percent. This period of time, however, was not without its highs and lows.

From 1922 to 1935, inflation decreased at a rate of 2.6 percent per year, meaning that an item priced at $100 in 1922 cost only $77 in 1935. Alternatively, inflation rates saw a dramatic increase into the double digits, from 1972 to 1982. An item that cost $100 in 1972 cost over $229 in 1982—a time when inflation was averaging 8.7 percent.

Over the long run, however, stocks will typically exceed inflation. According to a study by Dalbar, over a 10-year period ending December 2015, equity returns averaged 4.2 percent while inflation was at 1.9 percent; over a 20-year period, equity returns were at almost 4.7 percent while inflation was 2.2 percent.  This should further motivate investors to remain in the markets in order to preserve and grow asset value.

Invest with a Time Horizon in Mind

Despite historical highs and lows, inflation rates in the United States have been largely stable on average.  Knowing this, investors should assume a long term perspective with respect to investment risk, being mindful of their personal time horizon and when they might need to sell their assets.

All major asset classes such as stocks, bonds, and Treasury Bills showed very different returns over the short and long term. For example, from 1973 to 1982, stocks produced a cumulative real return of -16.85 percent.  Compare this to the period from 1926 to 2007, when stocks showed a cumulative real return of +882.37%.

Investors must be aware that there will be volatility in markets that will skew returns at certain points.  Rather than focusing on short-lived market waves, develop a strategy that protects you from the emotional biases of “jumping in and jumping out” of the markets, which can severely hinder long term returns.

Age, income, family dynamics, and other unique circumstances are all factors in developing a sound, comprehensive financial plan that considers all factors—investing, tax and estate planning, insurance and risk management, among others. Rather than playing a guessing game, and doing it alone, team up with a seasoned, fiduciary advisor who has your best interests in mind.

Tom Wilson, CFP® is a Senior Lead Advisor for JFS Wealth Advisors, a comprehensive financial planning and investment management firm with offices across Pennsylvania. With over 15 years of experience in the financial planning industry, Tom is dedicated to helping both individuals and businesses reach their financial planning goals through solution-oriented strategies.