What About Inflation?
Updated: Oct 13, 2021
With inflation hot on the headlines and the Consumer Price Index reporting on September 14th a rise of 5.4% over the last 12 months, dentists may be left wondering how to weather a future with increased costs to run a practice. Fed Chairman Jerome Powell makes the case that recent inflation is due to temporary factors, although higher than the targeted 2% inflation rate goal over time, and is caused by the recent rapid reopening of the economy. But this is little consolation for dentists who have already faced increased costs of doing business due to Covid (such as providing personal protection equipment, protocols, supplies, air filtration, etc.,) not to mention providing competitive salaries to maintain staff. What strategies can help dentists, including retired dentists on fixed incomes, save for the future and how do investors reach the critical investment goal to keep pace with inflation?
“Inflation is an important but often overlooked element of investing,” says Joel Hefner in the following video that discusses some of the factors to consider in striving to invest to outpace inflation.
Dentists may be wondering how their investments will stand against inflation, and looking to answers to questions such as-- Is this spike in inflation transitionary, or is it here to stick around? Will inflation continue to rise? What impact does inflation have on investments? Should I make any changes to my portfolio with inflation on the rise? And if inflation continues to rise, what are investment strategies may be able outpace inflation over the short and long-term? Let’s address the impact of inflation, the investment strategies and whether to make changes to portfolios based on inflation.
The Impact of Inflation on Investors—Should I be Concerned?
What impact does inflation have for investors on investment portfolios, and more importantly, their long-term financial goals? Obviously, the primary goal of investors is to increase the purchasing power of their investments, or in other words, to outpace inflation when saving and investing for long-term goals (spending those savings in the future).
For example, as shown in this illustration about the comparative cost of milk over time, if savings are left uninvested even a moderate amount of inflation can erode the purchasing power of those saving substantially over time. (“How Does Inflation Impact Investors”)
A convenient way to see how inflation can affect the value of a dollar over time in one convenient calculator is provided by the US Bureau of Labor Statistics (BLS) here where you can see the value of a dollar from any date to any other date, as shown
The last three decades have produced a moderate inflation rate with the annual increase in the consumer price index averaging around 2.3% per year; however, an uninvested dollar during that time period would have had its purchasing power reduced by about half (Gerard O’Reilly in Reuters).
What Strategies Can Help Investors Combat Inflation?
As we build and help clients implement an individualized financial plan and investment portfolio, we attempt to outpace inflation over the long-term by investing in the stock market. We also are aware of strategies to hedge against inflation over the short-term, but have chosen to minimize their use due to their risk.
Outpace Inflation
The stock market has historically outpaced inflation over the long-term. Investing in the stock market is best suited for investors who have the risk tolerance and capacity to be invested over the long-term. For instance, if you would have invested $1 into the S&P 500 index in 1926, after adjusting for inflation, this would have grown to $752 by 2020. Since 1926, inflation has averaged 2.9% per year while the S&P 500 has averaged 10.3% per year. (Matrix Book 2021: Historical Returns Data, Dimensional Fund Advisors, Page 16-17 & 76-77)
Hedge Against Inflation?
Not every investor is willing or capable to take the on the volatility of the stock market, especially if they either have a low risk tolerance or need to begin drawing from assets soon. These investors are likely invested in fixed income investments such as bonds, bond funds, CDs or money market funds. One possible option to attempt to outpace inflation while investing in fixed income investments is to consider making TIPS (Treasury Inflation-Protected Securities) part of your overall portfolio allocation. TIPS can mitigate the concern of unexpected inflation by changing their face value and subsequent interest payments, based on the consumer price index. Keep in mind, however, that TIPS can be volatile and a TIPS fund can go down 9% or more in a given year. Due to their volatility, although we may recommend these in specific situations and we will continually evaluate this option, we generally have not recommended that clients hold these in their account due to their risk.
We are often asked about what role commodities can play in hedging against inflation. Commodities can be extremely volatile, and because of this, we have not incorporated them into most client portfolios. The chart below from Dimensional’s article, “Are Concerns About Inflation Inflated,” shows the return of commodities and energy stocks compared to inflation over the last three decades.
Using commodities with this level of volatility to effectively defend against purchasing power loss is a questionable strategy (“Are Concerns About Inflation Inflated?”).
Should I Change What I Am Doing with My Investments?
Changing your investment strategy and/or portfolio allocation based on your feelings about inflation is a tricky game to play. Gerard O’Rielly, Co-CEO and CIO at Dimensional Fund Advisors (DFA) says that “Trying to outguess financial markets on the outlook of inflation is futile… Investors don’t need to outguess markets or undermine their portfolio objectives to outpace or hedge against inflation. They should, however, avoid overreacting to short-term fluctuations in consumer prices.” (Gerard O’Rielly in Rueters)
Simply said, DFA feels the best long-term strategy to ensure inflation does not eat into the purchasing power of your portfolio is to stay invested (US Inflation and Global Asset Returns, Research Paper Wei Dai, Dimensional Fund Advisors, Page 2). When discussing market timers who believe they can “know it when they see it,” Weston Wellington, Vice President of Dimensional Fund Advisors says the following in his article, “Everything Screams Inflation-- How to Interpret the Headlines:”
“A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back. It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat.”
With inflation concerns looming, the future remains uncertain. However, investors implementing the same long-term, time-tested and validated principle to stay the course with a willingness to bear uncertainty can also create opportunities, as we’ve witnessed thus far throughout the recent pandemic.