Inflation seems to be the word of 2022! We have not seen inflation rear its head in a very long time, and some have grown up not even hearing the term (outside of a classroom) before this year. Now that inflation is being spoken about daily we feel it is important to make sure everyone understands what it is and what it means.
Prices, over time, tend to increase and do not remain constant. As an example, a gallon of milk cost around $1.32 per gallon in 1970 and today it averages around $4.02. This increase is a clear example of inflation at work.
Purchasing Power of Your Money
Essentially inflation is the effect of reduced purchasing power over time. As in the milk example from above, the same $1.32 that allowed you to purchase a gallon of milk in 1970 would only buy a quarter of a gallon. That is a real-life example of how the purchasing power of your money has significantly declined over time. Understanding that this example shows this decline over a 50-year period we have experienced times where inflation grew at a much faster pace, like in the late 1970s, and a much slower pace like the early 2000s.
A better indication of inflation over time would be to look at a basket of diversified goods over time rather than simply just one product. Individual products can incur price increases over time by other forces than inflation alone. To illustrate this let us think about orange juice, if there was a weather event that impacted a vast majority of orange crops we would expect to see a large increase in orange juice prices (remember the movie Trading Places, this was what the Duke Brothers were trying to capitalize on). Is this directly a result of inflation? No, this is a result of supply and demand, and assuming the demand stays the same the supply will be impacted and not be as great.
This makes it important to measure purchasing power over time with a basket of goods, rather than a singular item. One of the best examples of this basket of goods is the Consumer Price Index or CPI. The CPI is a weighted index of a basket of goods in eight different categories whereby they measure the price changes to it over time, providing us with an idea of what inflation is looking like. This mitigates the impact of a single item price increase on the overall gauge of inflation.
Important for Planning
Why is inflation important when planning then? Well as you begin to plan for your future you cannot expect that you will need the same amount of money in the future, that you do today to live the same lifestyle that you will want. Inflation alone will drive costs higher and you must account for the impact. The longer the time frame you have until retirement the greater the impact inflation will have because of the number of years costs will be impacted.
Along the same lines, although saving money in the bank may be a safe way of accumulating assets it may not provide you with enough growth to even keep up with inflation. As an example, if you have accumulated $1MM in the bank and do not plan on using it for the next twenty-four years (just allows for easy math in this situation) and inflation over that time averages 3% per year, this will cause the buying power of that $1MM to decrease to only $500,000 assuming you are receiving no return on the monies in the bank. Should you be able to get a 3% return from the bank, then that will allow you to at least keep up with inflation but see no real return. I think you understand by now.
Diversification is Key
Inflation should be considered within your planning to help you stay on target of working towards your goals. To outpace inflation and actually have your money grow and the buying power too, you will need a mix of investments that will provide a return that outpaces inflation.
Make sure you are working with a fiduciary advisor that can help you address these concerns, evaluate your current circumstances and see what you should consider to raise the success of your plan and battle inflation.
This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice. Investing involves risk, including possible loss of principal. No strategy assures success or protects against loss. To determine what may be appropriate for you, consult your financial advisor.