I recently made my way to the lumber store. I enjoy doing small woodworking projects, and in this particular case I was making another set of cornhole boards. And I have made several of them in the past. I generally know before I go in there exactly how much the project is going to cost me. Like everyone else, I’ve heard the news that lumber has gone up 200-300% over the last year. And that building materials in general have gone up.
But it wasn’t until I was standing directly in front of the rack of 2x4x8 that it really hit me just exactly how much those prices had gone up. Because what I was now going to pay for one 2x4x8 was basically what I used to get three 2x4x8 for. And it made me think about the questions we have been getting from our clients around inflation and what it means for their portfolio and their financial plan. So we are going to answer some questions about inflation today, right after this break.
What is Inflation? How Does it Work?
So let’s just start with the basic question of “What is inflation and how is it measured?” Basically inflation is just a measure of the rise in the price of stuff. It can be anything from food, electronics, lumber in my case. Basically they are taking a look at the price of something last year, the price of it today, and how much has it changed. Often times it is measured in percentages, and when you hear the reports usually they reference two different percentages. one is the Consumer Price Index (CPI), and that just takes a look at a general basket of goods – what was it costing last year and what is it costing this year? In this particular case, that’s what you and I as consumers experience on a daily basis.
The other number we will often see referenced is the Core CPI or Core Consumer Price Index. This is oftentimes what governments or central banks will use to dictate their policy. That’s because the Core CPI removes the energy and food prices from the calculation. Because those two areas tend to be so volatile, they don’t want to be setting policy based on that volatility, they want something more stable. So for their purposes, they remove those categories for their calculations and purposes.
Another way to think of inflation: if we have 4-5% inflation, which is what some of the reports are showing us now, basically that means your carton of milk that cost $4 last year is now costing $4.17. And while that 17 cents doesn’t sound like a lot, basically you just took a 4-5% pay cut. The amount you are making today is now going to buy less than what it did a year ago. That’s where you start to see the impact of inflation on a daily basis for you and I as consumers.
How Does Inflation Impact My Portfolio?
Another popular question we have been getting around inflation: What effect will inflation have on my portfolio? I think it’s important to start off with the idea that inflation within reason is actually good for the economy. We want somewhere between 2-3% inflation is what most economists think is a good, healthy, growing economy. So we shouldn’t as an investor necessarily be scared of inflation.
What we need to be worried about is unexpected, high inflation. That’s where stock markets don’t like surprises. So if we are anticipating inflation of 2-4% but suddenly we start to see reports of 5-6% or higher inflation. That’s when we are going to start to see the stock market respond to that information probably in a more negative way.
But you also have to look at it from the standpoint of what type of investor are you? So generally speaking, a more aggressive investor is probably going to have more stock in their portfolio. So over the course of time, while there is going to be some volatility if we get unexpected or higher inflation, the advantage of being a more aggressive investor with stocks is that over time your portfolio will still outperform inflation. So your purchasing power will continue to grow generally speaking for someone who is a more aggressive investor.
There are certainly things we can do to optimize your portfolio and different types of investments we can do, but generally speaking a stock portfolio over time is going to perform above inflation. So aggressive investors have that slight advantage.
How Does Inflation Impact a Conservative Investor?
Where inflation becomes a bigger concern is if you are somebody who tends to be a more conservative investor. That’s where we see inflation potentially having a bigger impact on your portfolio. This chart that you see on the screen in front of you is from a report done by JP Morgan and this takes a look at $100,000 in a savings account and the interest you would have earned over the last not quite 20 years. And it compares it against the amount of income you need to be at inflation. So if we look back to the year 1995, savings accounts in that particular year would have earned somewhere between $5-6,000. Inflation would have eaten away at about $3,000 of that. You would have made as a conservative investor just in your savings account about $2,500 above inflation in 1995. But if you fast forward to 2008, we start to see the trend where a savings account or cash account is not even keeping up with inflation. So while you might be getting your statements and looking at those and saying well I’m not losing any value. My CD or savings account has not gone down in value. But it has lost purchasing power. In 2007 was the last year where you made enough in a savings account to beat inflation. So that’s where we start to see inflation become a bigger concern for individuals who tend to be more conservative and keep more of their money in cash.
How Does Stewardship Advisor Help Prepare for Inflation?
So finally, the last question we will address here: What is Stewardship Advisors doing to help navigate this time period? Some people believe this inflation is short-term, it’s due to lack of supply. As industries and businesses had to shut down because of the pandemic, it’s not like you can just flip a switch and production is back to where it was beforehand. It’s going to take a little bit of time until the supply meets the demand. In that case, some people say it is short-term.
Other people say the inflation concern is longer-term. What are we doing to navigate this time period for you?
It really comes down to three points:
We are going to continuously review your Wealth Stewardship Plan. So if you flip through that document, there are going to be a number of strategies that we are working with you on a regular basis. The strategies we want to review with you each time we meet. Maybe we need to make a change to your investment portfolio because we need to pick some different investments or look at different areas to combat the rise of inflation on your portfolio.
We want to regularly review your financial planning projections. All of our projections include a certain level of inflation. So if it is a short-term inflation period, we probably don’t need to make any changes to our calculations. However, if inflation does go on for a longer period of time, then we need to revisit those projections to see whether we need to make some adjustments to the savings plan or the income plan. The nice thing about our planning tools is that they are all integrated together, so we can get a good look at how inflation is affecting not just the investments but also the plan over time and whether we need to change anything there.
This is a reminder that we tell people all the time: Remember to focus on the things we can actually control. We can’t control inflation; we can’t control how the stock market responds. It’s important to be in regular communication with your advisor. We send out those Life Transition Surveys every so often, and there are 52 life transitions listed on there. The most important thing we can do is continuously communicate what life transitions you have coming, so we have money set aside for you that is going to absorb the rise in inflation if it does come. So that planning aspect is really where the value of working with a financial planner is going to come into play for you.
Hopefully, that helped answer some questions you had around inflation. If you have any more, please don’t hesitate to reach out to us.