Article
What is inflation?
How can inflation affect you on a daily basis? The finance text books define inflation as an increase in prices. What this definition leaves out is the impact of time and persistence. At Abacus we like to think of inflation as a very small hole in a very large bucket of water: the small hole makes it hard to notice the water level as it falls on a day-to-day basis, but over a long period of time the small hole will drain out all the water. Just like the small hole in the bucket, the consistency and invisibility is what makes inflation so dangerous. To help counteract the impacts of inflation, a well-designed portfolio should consider the impact of inflation on future expenditures and goals and should emphasize inflation as equally as stock market swings.
Documenting inflation seems to be about as difficult and debated as the definition of inflation. Central banks and government agencies report inflation statistics. These Government statistics are then used to make adjustments to tax and benefit calculations. While the government figures are widely disputed, these figures are still the most detailed data available—and government data on inflation can be very helpful when thinking about trends. For example, consider the following data (according to the Bureau of Labor Statistics): The cost of college tuition and fees has increased 78% from 01/2004 to 09/2014; the cost of physicians’ services has increased 32% from 01/2004 to 09/2014.
How does this affect you?
When you are saving and investing for future goals, it is a good idea to think about how fast prices are increasing (or decreasing) for your specific financial goal. Once you have a savings range, you can look for what types of investments are best suited to help you meet those goals.
In the stock and bond market, inflation is the foundation of valuation models. To help better understand, try this: Imagine you are offered two options—a 10% return accompanied with 7% inflation, or a 6% return accompanied with 2% inflation. Insofar as purchasing power, the 6% return increases your purchasing power more than the 10% return. This same thought process occurs each day in the stock and bond market. The result of this daily exercise is that return expectations are adjusted up and down, according to inflation. When you are thinking about return expectations for your goals over a 7-10 year period, taking inflation expectations into consideration creates a better estimate than just looking at historical returns.
How do you create an inflation estimate?
One way to create an inflation estimate is to look at the difference between the yield on a US Treasury Bond versus the yield on a US Treasury Inflation Protected Bond. Since US Treasury Inflation Protected Bonds are adjusted by the changes in the Consumer Price Index and US Treasury bonds are not adjusted, the difference between the two bonds is what Treasury bond market investors think inflation will be. Even though this difference is an educated guess, that guess can be a good starting point when you are building your inflation number.
Staying focused on what matters
The financial press usually focuses on earning announcements and index levels, but inflation is equally as important. Over a long period of time, inflation has the potential to be much more devastating to your goals than market swings. To avoid having inflation be the silent killer of your lifestyle think about how inflation will impact your future consumption and spend as much time preparing for the impact of inflation as you do preparing for the next market drop.
