Inflation is a general increase in the price of goods and services, and decrease in the purchasing value of a currency – essentially, it is measuring the temperature of the economy of a country. In addition to the broader implications of inflation on the economy of a country, it also affects one’s personal finances. Inflation is measured by the consumer price index (CPI). The CPI reflects the value changes in a basket of consumer goods and services, which are often adjusted to factor consumption patterns of the average consumer. Yet many people don’t consider the impact of inflation on future financial planning, seeing as the average American doesn’t keep up with inflation. It is something that should always be taken into account, especially when it comes to investments that will provide retirement income. Here are the 4 effects of inflation on your personal finances.
The Effects Of Inflation On Your Savings
Inflation affects specific aspects of one’s personal finances differently. One area that is perhaps most susceptible to inflation are cash investments like a savings account. Because money is readily accessible, some people prefer to keep it in a savings account rather than invest it. Yet, as time passes, the value of money kept in a savings account can lose its value, considering that prices generally increase in the future. What you could purchase with $20,000 25 years ago, isn’t the same as the value of $20,000 today in 2019. In essence, the purchasing power of money may decrease while it sits in a savings account at a bank.
For instance, if a savings account contains $1,000 with an interest rate of 1%, by year’s end the account will have $1,010. If the rate of inflation is running at 2%, then there must be $1,020 in the account to have the same purchasing power that was started with. It’s important to remember, that interest gained in a savings account never keeps pace with the rate of inflation.
In essence, inflation will eat away at one’s purchasing power, because not only will the money lose value, it won’t gain anything either. This can be a cause for concern during retirement when you have less earning power. To protect the purchasing power of your savings from the rate of inflation, it would have to grow at or beyond the inflation rate. An effectual way to beat the effects of inflation on your savings is to invest some of those savings in the stock market.
The Impact Of Inflation On Stocks
Investing money in the stock market inevitably comes with a higher level of risk than simply keeping money in a savings account. Yet, as time passes, the stock market is expected to be able to handle or exceed the rate of inflation. Because of this fact, some investors prefer to invest their money in potentially higher growth investments like stocks. For those who prefer to avoid the volatility of individual stocks, another option is mutual funds, which usually provide good returns and are professionally managed. Furthermore, index funds might be an even better alternative for some, as they aren’t reliant on a fund manager, and follow their benchmark financial market index.
However, apropos of stocks, inflation still affects the value of the investment. The value of a stock is dependent on the performance of a company. When the economy is strong, inflation is usually high. During these periods, a company may have increased revenue and earnings, which would help their share price. However, as inflation rises, the company would have a larger expenditure for things like wages or raw materials – thus, affecting the company’s value. Additionally, akin to any other return, the stock’s return value will decrease as purchasing power decreases over time.
The Effects Of Inflation On Bonds And Treasury Bills
Debt securities like bonds and Treasury bills are fixed-income assets that payout the same amount each year. These assets are not as affected by inflation as money in a savings account. However, when the rate of inflation increases faster than the return on debt securities, their value depreciates. Earnings diminish as purchasing power declines with the rate of inflation.
One option, especially for those in their retirement years, is Treasury Inflation-Protected Securities (also referred to as TIPS). These forms of inflation-protected bonds are indexed to inflation, therefore protecting investors from the adverse effects of increased prices.
Property Ownership And Inflation
Property ownership is perhaps the most beneficial during periods of high inflation. As inflation increases, so does the value of the property. If you have a fixed-rate mortgage on a property, then the cost of the monthly mortgage payments will decrease as time passes.
However, because most people purchase properties with mortgages, higher interest rates could dissuade people from increasing their debt-load. Therefore, the demand for property decreases, making it more difficult to resell.
Warren Buffet And The Matter Of Inflation
Preeminent investor Warren Buffet has long been a leading authority on inflation, as he is both focused on and fearful of it. In fact, lest it be forgotten, that prior to the financial crisis of 2008, Buffet, the CEO and chairman of Berkshire Hathaway warned that inflation would cause a collective upset – which it did.
In 2010, after the world was wrestling with the effects of the financial crisis, Buffet wrote a “tongue in cheek” thank you note to the US government.
“We are following policies that unless changed will eventually lead to lots of inflation down the road,” Buffet stated on an op-ed.
In his classic piece for Fortune in 1977, aptly titled How Inflation Swindles the Equity Investor Buffet succinctly outlined his views about the effects of inflation on investors.
“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market’s problems in this period are still imperfectly understood.
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.
It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might.”
Despite the fact that Buffet wrote this 42 years ago, certainly words of wisdom from an individual who is legendary for his investing prowess and sagacity pertaining to finance.
Planning For Inflation
Inflation is a financial component of life that cannot be avoided. However, there are things that can be done. Keep abreast of monthly inflation rates and CPI, via the Bureau of Labor Statistics release schedule. If inflation goes above the 3% level, it could be an indicator of worse things on the horizon. Factor in inflation when investment planning, especially with regards to fixed-income investments. Lastly, when planning for retirement, expect that the rate of inflation will be exponentially higher in the coming decades, rather than decreasing. Also, keep abreast of the market value of gold with a gold calculator. All are good ways to protect your personal finances from the possibility that the rate of inflation increases.