How to Think About Inflation

How to Think About Inflation

October 3, 2021

How to Think About Inflation

How to Think About Inflation

October 3, 2021

It's always a risk, but maybe not what you think

Many investors are worried that the 1970s may be coming back. Not cassette tapes, but high inflation.

Before you change your financial plan, pause and think carefully about how to manage the risk of inflation. You probably need to do less than you think.

I believe the real risk of inflation is not what is generating recent breathless news reports -- inflation hitting 5% vs 2-3% long-term averages.

The real inflation risk is the same as always. Over time, your dollar will buy less. If you put $1 into a mattress 30 years ago, today it would buy half of what it would have bought then -- even though inflation was low.

So what do you do?

If you have a long-term goal, like affording retirement over the next 20+ years, own plenty of stock. During the past 100 years, US stocks beat inflation by more than 7% annually. Stocks beat inflation every decade except one: 2000-2009, when inflation was low. Maybe the next 20 years will be different. But the odds are with stocks.

If you have a shorter-term goal - maybe buying a car in 2 years - consider a product like US TIPS (Treasury Inflation Protected Securities). They are government bonds that adjust their price and interest payment based on inflation. For a short-term goal, you should not buy stocks, because they can decline suddenly. But TIPS could protect you from an unexpected burst of inflation.

What shouldn't you do?

Change your financial plan. Inflation is only one of many risks you face. Reacting to short-term economic developments - inflation moves, interest rate changes, stock market crashes and real estate bubbles, to name just four - may damage your plan.

Buy a lot of a niche investment because you think it will beat inflation. Real estate, gold, other commodities and even cryptocurrencies are often mentioned as providing protection against inflation. The evidence is shaky for all of those assets classes except real estate. But even with real estate, you should be careful. Putting a large share of your net worth in any one kind of investment creates risk. In an unpredictable world, diversification is almost always the right answer.

Panic. Whatever the next concern, it will likely be short-lived. Too many times, we act in haste and regret our actions afterwards. If you have not read it, please check out Thinking Fast and Slow, by Daniel Kahneman. It explains why humans often make poor decisions and how you can avoid doing so.

Inflation is yet another worry in the never-ending game of investor whack-a-mole. Don't play it.


Acknowledgement: Some of the data and perspectives came from Dimensional Fund Advisors. I thank them, as always, for their research and insights.

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