These days, filling up your gas tank or stocking up at the grocery store can really take a chunk out of your budget — a direct and simple reminder of the devastating effects inflation can have on your dollar’s purchasing power.
But how does that affect your investments?
To answer that question, we first have to define what we mean by “investment.”
From our perspective, we see investment as a way to safeguard your wealth from the effects of inflation, allowing you to continue enjoying your current lifestyle after retirement, and potentially leave behind a legacy for your kids and grandkids — not high-risk speculation seeking enormous short-term returns.
But to do this successfully, you need a solid investment strategy.
How does inflation affect your retirement?
If you were to save $10,000 in a low-interest savings account paying 1.3% — and the inflation rate averages 3% — after 10 years the purchasing power of your $10,000 will have dropped to $8,499.66.
To keep pace with inflation, your money needs to generate a return at or above the rate of inflation — while still maintaining enough liquidity to satisfy deduction quotas during retirement.
How inflation affects financial assets
Not all types of financial assets behave the same during periods of rising inflation. Some lose value, while others retain or even increase in value. It all depends on the nature of the investment, and how inflation affects the interest rate.
Think of inflation and interest as being on either side of a scale. When inflation rises, the Bank of Canada has to increase interest rates to “cool” the economy and depress the demand for goods and services, creating downward pressure on prices and bringing the scale back in balance.
If you have money in high-interest investments, this may seem like a good thing — but the interest you’re earning doesn’t keep pace with the inflation rate, and the purchasing power of your dollar falls.
And if you have a portfolio that’s heavily invested in bonds, rising interest rates have a tendency to push bond prices down — once again diminishing the purchasing power of your dollar.
Growth & equity investments, on the other hand, tend to do a better job keeping pace with inflation. Businesses with a long history of success and a desirable product or service (who can raise their prices along with inflation) may even appreciate in value while others fall.
So, how do you know where to invest your money?
What can you do to “inflation-proof” your investments?
The best way to protect your wealth is to have a diversified investment portfolio based on your current and future needs, your risk tolerance and your goals (a good financial advisor can help you figure this out).
A diversified portfolio has a combination of growth/equity investments and bonds, but the ratio varies from individual to individual. Someone who is still earning a good income, for instance, wouldn’t have much use for the liquidity of bonds compared to someone closer to or in retirement.
So, as your needs change, so should your investment portfolio. When you’re in a position where it’s necessary to withdraw funds, you’ll need access to more liquid assets, such as bonds.
This concept is explained in detail in our post about the cash wedge strategy, but basically, you would use the growth from your investments in stocks and mutual funds to purchase bonds and fund the “cash” wedge of your investment pie.
When inflation rises, don’t panic.
Inflation is part of our economy and is a bit like Goldilocks. When inflation is high, the economy can suffer. When it’s too low, the economy can become stagnant (as in a recession). But when inflation is controlled it is just right — people are working, consumers have enough money to buy goods and services and the economy grows.
So inflation in and of itself is neither good nor bad — you just need to make sure your portfolio is sound and diversified enough to weather any storm.
• Invest in commodity equities — some commodities, such as oil, lumber, grain and precious metals actually benefit from inflation (the price of gas seems to rise and fall with inflation). It’s also a good idea to include some foreign investment, as their economies may be affected in different ways.
• Consider Real Estate Investment Trusts (REITs) — it’s no secret that inflation raises the price of real estate across the board. REITs are companies that own and operate real estate holdings that generate income from rents, capital gains and appreciation. While it is possible for real estate to lose value, historically that has not been the case.
• Include some short-term bonds — dedicating a portion of your portfolio to short-term bonds will cushion it from volatility and give your portfolio some liquidity. How much you have invested in bonds depends on how soon you’ll need the cash.
• Seek financial advice — if you’re not sure how to safeguard your wealth from inflation, it’s always a good idea to reach out and talk with a financial advisor. They’ll help you identify your needs, goals and risk tolerance so you can develop a solid plan.
You can’t stop inflation, but you can shield your savings from it by making wise investment decisions. If you’d like to explore the different ways you can inflation-proof your portfolio and execute a plan that works best for you, schedule a meeting with one of our advisors.