Tactics for Limiting the Impact of Inflation
Does inflation concern you? Consider these tactics for limiting its effect on your financial well-being.
Inflation has been one of the main concerns that have arisen over the last year as we collectively attempt to resume our lives following the onset of the Covid-19 pandemic. There are daily reminders that consumer prices are rising, which appears to be the result of a confluence of factors, including increased demand for goods and services following the shutdowns of 2020, supply shocks caused by a reduced labor force, and public policy making it cheaper to borrow money. Even with prices rising, there are ways you can limit inflation’s effect.
Tactic #1 – Substitute
The consumer price index is a measure of the average change in prices over time. When the prices of all goods and services were measured in November 2021, prices were 6.8% higher than the same time last year. But this is not the entire story because not all categories of expenses rise at the same rate. For instance, if you were in the market for a new vehicle in November, you would have found that prices for new cars went up at about one-third the rate of prices for used ones. This is why substituting is the first tactic for managing the impact of inflation.
Think about your past visits to the grocery store. When you see price spikes in certain food categories, you have a choice. You can either absorb the price increase by paying more for your grocery bill overall, or you can substitute something else for that food item to help manage your costs. This is possible for most things you buy. The exception of course are those goods and services which are essential and have few substitutes. Gasoline is a good example of an exception, but even it can be managed to some extent, especially if you have some financial margin built into your budget.
Tactic #2 – Reduce
Inflation impacts prices, so it should go without saying that the more you spend the more it will affect you. If you spend every dollar you earn, then you’re positioning yourself for trouble if inflation persists. In this case, you should look for ways to reduce your expenses so that you have some financial margin. Just a 2% margin on $5K worth of income each month equates to $1,200 per year. This can be a real difference maker.
To create margin, think of your expenses as either necessary or discretionary. Necessary expenses are few and include: insurance, food, basic housing, utilities, and basic transportation. Everything else is discretionary and these are the expenses that you should consider reducing first. Making changes to necessary expenses is more extreme but may be required if you’re not able to create enough financial margin by reducing discretionary expenses alone.
Tactic #3 – Delay
When prices are rising there is an implicit pressure to buy immediately. This is so because we think that prices will continue rising unchecked into the future. This is not necessarily the case and is sometimes the rationale used to justify spending for which there wasn’t any planning or saving done ahead of time. An example of this thinking that occurred on a massive scale was the housing boom of the early 2000s.
According to the Federal Reserve, median sale prices for houses were increasing at an average annual rate of 6.5% between 2000 and 2007. This was more than twice the rate in the prior ten-year period. There were murmurings of a housing bubble but people continued to buy anyway. Many of the people who bought at these elevated prices did so because they feared that delaying their purchase would only make it more expensive to buy in the future. They then saw the value of their homes crater when the market crashed. For those that chose to delay purchasing a home, the housing crash provided an opportunity to buy at significantly lower prices than what homes had been selling for just a few years earlier.
Tactic #4 – Invest
Investing, in general, has been the greatest way to outpace the effects of inflation over the long term. Stock-oriented investing is especially beneficial because companies have a single purpose: to make money. If they don’t make money, they cease to exist. As such, companies are experts at all of the tactics listed above and they are also experts in developing and creating products that are demanded by consumers. These traits make companies uniquely gifted at navigating all manner of obstacles, including inflation.
In addition to stock investing, owning rental property personally or via a REIT can also be a good way to outpace inflation because rents can be increased periodically. The purchase of Treasury Inflation-Protected Securities (TIPS) also provides a shield against inflation because the principal amount of the bonds is adjusted with changes in the consumer price index. This allows the face value of the bond to be maintained over time. Other inflation hedges include investing in commodities and precious metals like gold, but these tend to be highly volatile.
Balancing risks like inflation and the need for growth underscores the importance of asset allocation when developing and managing an investment portfolio. If this is not something you are confident doing on your own, you should seek help from a financial advisor.