FRIDAY, MAR. 9: In the past couple of years I’ve noticed that every time I head to the supermarket to buy groceries or fill my car up with gas, prices have increased.
When I pay my utility bills or cover additional costs for medical care, prices seem to be increasing more and more.
The services haven’t improved, the products are no different but the costs are ever-increasing.
The question is how do we deal with the cost of inflation — we can’t control it, we can’t diversify from it, and more importantly we can’t avoid it.
By definition, inflation is a rise in the general price level of goods and services in an economy over a period of time.
When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.
The question for the average investor is: ‘How does that affect my investments and what type of rate of return do I require in order to pace above it?’
This is an especially important issue for people living on a fixed income, such as retirees.
The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, inflation should not keep you up at night.
Over the long run, a company’s revenue and earnings should increase at the same pace as inflation.
The main problem with stocks and inflation is that a company’s returns can be overstated. In times of high inflation, a company may look like it’s prospering, when really inflation is the reason behind the growth.
When reviewing the financial statements, it’s also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value its inventory.
The greatest impact will be felt through fixed income investments; fixed income recipients will feel the greatest pain because while inflation increases, their income doesn’t, and therefore their income will have less value over time.
In the simplest terms, here’s an example. Currently we have a financial environment that offers low interest rates to invest ie. one per cent for a one year deposit with an inflation rate of three per cent.
After that year, interest is received for the amount of money invested.
The purchasing power for the money that was locked away for the year will have less value than before it started.
If you are looking to invest, you must seek returns/interest rates that pace above inflation.
So how do we try and combat inflation? Be wise when sitting on cash in your savings account.
If you are earning 0.25 per cent interest on the money you have in your bank account and the inflation rate is three per cent, then you are losing purchasing power.
If you have a variable-rate mortgage, switch to a fixed rate if you can find a rate that is low enough.
Invest for long-term capital gains, as short-term investments tend to give deceptive results or a sense of making profits when in reality you are not.
Reduce consumption of things rising rapidly in price (eg. gas) without reducing consumption of goods rising less rapidly or falling in price (eg. clothes).
Inflation does exist and how you choose to manage your investments and spend your money is equally as important.
Carla Seely is a senior wealth manager at AFL Investments. Contact 294-5712 or e-mail firstname.lastname@example.org.