by Bren Iramina and Paula Stumne
While higher inflation can be worrying, a modest amount of inflation can actually encourage spending, borrowing and lending, which in turn keep the economy strong and growing. We’re seeing signs of a strong economy today, with low unemployment, rising wages and healthy amounts of consumer spending.
The Federal Reserve’s long-term target for inflation to ensure “maximum employment and price stability” is 2%1. When inflation climbs past that target, we see another effect – consumer purchasing power decreases. Many companies pay higher wages but also pay more for materials, so in turn, they must charge more for their products or services. For those on fixed incomes or who are retired, these elevated costs can be especially challenging. Finally, high inflation can cause uncertainty in the stock market due to a slowdown in spending, and bond prices can be impacted too.
As we experience all the effects of inflation over time, it can be hard to know how to manage your finances while also optimizing your investments. Here are some suggestions.
Start with the basics
Taking a look at your financial plan makes a lot of sense in an environment with higher inflation. Or, if you don’t have a financial plan, now is a great time to create one! Most financial plans start with a budget. Be aware of the impacts of higher costs for goods and services as you review your budget and adjust as needed. That may mean less discretionary spending (eating out, etc.).
Remember to keep an eye on your goals (both short- and long-term) and speak to your financial advisor about the impacts of the current market on these goals and your overall financial plan. Make sure you also understand your cash flow needs. Your spending is likely different every year, and for most of us, our spending increases year over year. Organize and keep track of your expenses, pay down credit card debts, and develop and adhere to your savings goals.
Focus on diversification
With a strong financial plan as your base, you can turn your attention to your investment strategy. It’s important to stick to the principal of diversification and consider the risk versus reward of each asset class when you invest. Investment risk is risk in investment assets. You can reduce certain types of investment risk by investing in different asset types. All investment accounts have investment risk, and there are a few types of investment risk that can and will impact your accounts. These include:
Credit risk: Risk due to the borrower not repaying the loan.
Inflation risk: Risk of loss due to rising prices of goods and services.
Interest-rate risk: Risk due to interest rate fluctuation.
Equity risk: Risk due to changes in stock prices.
Commodity risk: Risk due to changes in the price of commodities.
Reducing investment risk with diversification is an important part to your investment strategy. For example, investing in all fixed-income bonds will reduce equity risk, but would mean you have credit risk and inflation risk. Having a cash-only account would eliminate multiple types of risk, but now you are losing purchasing power because of inflation. Stocks are generally seen as a good hedge to inflation, but they come with equity risk. You cannot eliminate all types of risk from your investment portfolio, but you can reduce the impact of certain risks with diversification.
Once you have the fundamentals down, discuss other strategies with your financial advisor. There might be options that you didn’t think of, such as hanging on to lower interest rate debt and taking advantage of higher interest rate accounts instead of paying off debt at a lower rate. With the Fed increasing interest rates, this has also resulted in higher rates on certificates of deposit, money market accounts, bonds and Treasury bonds.
Speak with your advisor regularly to review your goals and optimize the diversity in your accounts. If you have multiple accounts with multiple advisors, it’s a good idea to have at least one advisor who can view all your accounts to make sure that they work in concert with one another rather than against each other.
Inflationary times can be challenging for investors. However, you can find some peace of mind by employing fundamental financial strategies and diversifying your investments.