The Silent Thief - How Inflation Changes Your Financial Future
May 30, 2023
The ultimate financial goal is to create total income replacement through investments. For the medical professional, this means you no longer have to work for income. Your stock/bond portfolio, investment real estate, etc generate enough income for you to live comfortably - indefinitely.
Inflation, the gradual increase in the prices of goods and services over time, will erode the purchasing power of our savings and investment portfolio. If you've been anywhere other than living under a rock for the last few years, you've noticed firsthand how inflation shapes your buying power.
Understanding Inflation's Effect on Investments
Inflation has a profound impact on various investment vehicles, such as stocks, bonds, and real estate. Let's consider the potential consequences of inflation on each of these asset classes:
- Stocks: Inflation tends to drive up the cost of raw materials, wages, and other factors of production, impacting companies' profitability. Consequently, the prices of stocks may rise to keep pace with inflation, but this may not necessarily result in real gains. This is the difference between looking at only nominal returns (total returns before considering other factors) and real returns (which are returns after factoring in inflation, taxes & fees). Equities, or stocks, have historically produced positive REAL returns the majority of the time, with recent exceptions being the 1970s and 2000s.
- Bonds: Inflation will essentially erode the fixed income earned from bonds. When the purchasing power of future interest payments decreases, the value of the bond diminishes. Investing in inflation-protected bonds, like Treasury Inflation-Protected Securities (TIPS), can provide a hedge against inflation.
- Real Estate: While real estate is often considered a hedge against inflation, its performance can vary depending on the overall economic conditions. Inflation can drive up the cost of construction materials and property taxes, impacting real estate values. However, rental income from real estate can increase during inflationary periods, which would ultimately preserve your purchasing power.
Planning for Retirement in the Face of Inflation
To determine the age at which you can retire and maintain your desired standard of living, it is crucial to consider inflation when creating your retirement plan. Here are some key considerations:
- Inflation-adjusted expenses: Estimate your future expenses by factoring in inflation. While it is challenging to predict inflation accurately, assuming a conservative estimate of 2-3% per year can provide a starting point for planning purposes. For example, in order to purchase $100,000 worth of things throughout the year in 2023 dollars, you would need $287,000 in 2053 to purchase the same things (assuming a 2% inflation rate).
- Diversification: A well-diversified investment portfolio can mitigate the impact of inflation. Allocate your assets across different asset classes and geographical regions (particularly with physical real estate) can reduce the risk associated with inflation-sensitive investments.
- Regular portfolio review: As you approach retirement, regularly review your investment portfolio to ensure it aligns with your retirement goals. Adjust the asset allocation based on your risk tolerance and expected retirement date.
- Consider professional advice: Once you have invested your way to a several hundred thousand dollar portfolio, your overall complexity will rise. In addition, you may be nearing retirement. Seeing the assistance of a financial planner may be wise at this time, with a deep understanding of the fees you are paying. If you're not familiar with fee structures, click here.
Wrapping It Up
Inflation is an ever-present force that can significantly impact your investment portfolio and retirement planning. Recently, high inflation has crystallized for most of us how much this can effect your budget & monthly cashflow. Failing to account for inflation in retirement planning will directly result in a diminished standard of living during retirement.
To retire comfortably and maintain your desired standard of living, it is crucial to create a well-diversified investment portfolio, account for inflation-adjusted expenses, and regularly review your retirement plan. You will never arrive here without proactive planning.
If you're not yet on track to fully replace your inflation-adjusted annual expenses in retirement (or you don't know where to start), we're here to help.
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