The Impact of Inflation on Your Investments and Savings
Inflation can erode your wealth and decrease your purchasing power. Here’s a look at how it works and why keeping money in cash is rarely as safe as it seems.
A few years ago, a story hit the newsstands about a coat somebody donated to Goodwill with $43,000 in the pocket. Wouldn’t it have benefited the owner more if she had kept her cash in investment vehicles rather than the proverbial mattress? In this article, we explore the risks of not allowing your cash to keep up with inflation and how inflation impacts your savings and investments.
Inflation defined
Let’s start with a definition. Inflation is the rise in prices of everyday goods and services. Put differently, the purchasing power of a dollar falls when the price of goods and services goes up. For example, if a car costs $20,000 today and the current inflation rate is 4%, that car will cost $20,800 next year, assuming the price goes up in line with inflation.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for a market basket of goods and services. It’s the most popular measure of inflation. According to the Bureau of Labor Statistics, the CPI for all urban consumers (representing 93% of the total U.S. population) rose 5% for the 12 months ending March 2023, which is the smallest 12-month increase since the period ending May 2021.1
Over the course of American history, we have experienced both inflation and deflation. The Federal Reserve (Fed), which is charged with monitoring and implementing monetary policy with respect to inflation, does not have a set number for an “acceptable” inflation rate. Most economists, including many of those at the Fed, think the informal consensus by policymakers is an inflation rate of around 2%.2
Following a prolonged period of rising inflation from after World War II until the late 1970s, inflation declined steadily until March 2021 (see chart below). Inflation has since increased due to factors such as higher demand during COVID-19, supply chain shortages, transportation delays and the war in Ukraine.
Source: U.S. Department of Labor
How inflation affects your savings
When markets are volatile, as they have been over the past few years, it can be easy to understand why investors may choose to hold more cash, particularly if inflation is not an issue. Cash is often viewed as a safe way to preserve principal. If, however, inflation returns, there is likely a greater risk that cash will not maintain its purchasing power.
Here’s a way to understand the impact of inflation on your savings: Let’s say you have $1,000 in a savings account that pays a 1% interest rate. In a year’s time, your balance will grow to $1,010. But if the rate of inflation is 4%, you would need $1,040 to have the same purchasing power that you started with.
When the growth in savings does not increase at the same rate as inflation, there is no loss of nominal value, but those savings will not buy as much as they did the year before. One would have to save more, spend less or accept a smaller net worth over time because inflation is decreasing the purchasing power of the capital, as the following chart shows.
Source: Segall Bryant & Hamill
How inflation affects various investments
The impact of inflation on your investments depends on the type of investment.
Bonds: Bonds have a key place in many investors’ portfolios, particularly for those in retirement (or approaching retirement), as they can serve as guard rails to brace your portfolio in periods of stock market volatility.
Bonds are not, however, immune to the impact of inflation. The purchasing power of the cash received from your fixed coupon payments will decline unless you reinvest the coupon payments at successively higher interest rates and/or into a diversified portfolio of stocks.
In an inflationary environment, a comparatively low yield on bonds may have trouble competing with the higher cost of purchases. In addition, we believe it’s important to keep in mind that, compared to shorter-term bonds, longer-term bonds increase the chance that higher inflation could reduce the value of the payments to the investor over the life of the bond.
There are bonds, however, that can help protect against inflation. Treasury Inflation-Protected Securities, or TIPS, were designed to do just that. These bonds, which have U.S. government backing, are indexed to inflation and pay investors a fixed interest rate as the bond’s par value adjusts with the inflation rate.
Stocks & Commodities: Stocks also play an important role in portfolios, and historically, they have shown better real returns than bonds in rising or high inflationary periods.3 Inflation can directly impact stocks in two opposite ways that tend to largely offset each other.
The first way inflation can affect stock prices is by causing a decline in their value. This has to do with how we value the future income of each company. When you buy a stock, you are purchasing the future cash flows of the company based on its profits. The value of the company (and its stock price) is based on what those cash flows are worth today. This calculation is referred to as a stock’s present value and is determined by discounting those future cash flows at a rate that takes inflation into account. So, if inflation rises, all else being equal, the discount rate used in the calculation will be higher, which will make the present value of the company lower and may cause its stock price to decline.
Conversely, inflation can also cause stocks to increase in value. When inflation occurs, a business can often pass along the higher costs involved in running its business to its customers. This can lead to growth in its profits and higher cash flows, which in turn can lead to a higher present value for the company and an increase in the stock price over time.
Commodities such as gold and silver, futures on things like food, energy and industrial materials4, and real assets such as real estate are also considered ways to offset the impact of rising inflation. That’s because their prices typically rise when inflation is accelerating, thereby offering protection from the effects of inflation.
How to mitigate the impact of inflation
As an investor, we believe the main thing you can do is focus on how your investments are distributed across cash, bonds, stocks and commodities to reflect your goals and mitigate the loss of purchasing power over time. Remember that while having at least some cash on hand for an emergency is generally prudent, the veiled reality is that those dollars will almost surely be losing ground to inflation—so plan accordingly.
1 https://www.bls.gov/news.release/cpi.nr0.htm
2 https://www.federalreserve.gov/faqs/5D58E72F066A4DBDA80BBA659C55F774.htm
3 https://money.usnews.com/investing/investing-advice/slideshows/investments-to-offset-potential-inflation?slide=3
4 https://money.usnews.com/investing/investing-advice/slideshows/investments-to-offset-potential-inflation?slide=4
