Inflation and Investing: what happens when the two shall meet?
The annual inflation rate for United States was 3.3% for the 12 months ending May 2024, according to the U.S. Department of Labor. The following chart summarizes inflation rates over the last ten years.
Source: US Inflation Calculator
Coming out of 2021-2022’s historical high inflation, investors are concerned about inflation and its long-term impact. Here are a few common questions from our clients.
What causes inflation?
Although many factors contribute to inflation, there are a few major ones that come into play.
Supply and demand: Inflation rises when consumer demand for goods and services is disproportionately higher than supply. The high rates of inflation from 2021-2022 happened when there was a disruption in the supply of goods and services during the Covid pandemic. See this article from the BLS about the impact of COVID on inflation (Leith, 2023).
Natural disaster factors: Natural disasters can drive up prices for goods and services. One example of this is property and casualty insurance for homeowners and auto insurance policies. In California, premiums for this coverage are at record highs. Even non-staple items such as chocolates have become elevated, according to NPR (Rascoe, 2024). Better stock up!
Other factors such as money supply, unemployment, and rising interest rates all contribute to inflations, according to Harvard Business Review (Frick, 2022).
Should I invest in Gold?
Gold is viewed as a potential tool for protecting wealth from rising prices. However, gold has not lived up to its reputation if you examine its performance history:
It’s important to note that gold has shown extreme price swings when compared with changes in the inflation rate. An inflation hedging tool would need to display volatility levels that are more on par with changes in consumer prices to be effective.
Also, gold and inflation sometimes move in opposite directions.
Lessons could be learned from 1973-1979 when the U.S experienced its last bout of high inflation, about 8.8%. During those 6 years, gold did provide an impressive return; however, from 1980-1984, gold prices dropped an average of 10% each year. From 1988-1991, while annual inflation averaged about 4.6%, gold prices were down approximately 7.6% a year on average.
In 2021 and 2022, while inflation was at multi-decade highs, gold prices were down.
Source: Dimensional Funds
Will Inflation hurt stock returns?
Not necessarily! According to Dimensional, historical performance shows that markets may be volatile over the short term, but stock returns have been remarkably consistent when measured over decades. From 1994-2023, the S&P 500 posted an annualized return of 7.5% after adjusting for inflation.
What can I do to mitigate the impact of inflation on my wealth?
If you are highly sensitive to inflation and have a low tolerance for market risk, then consider using Treasury Inflation-Protected Securities (TIPS) as part of your portfolio. Another fixed income option is to consider I-bonds.
The mix of stock and bonds within your portfolio is highly personalized and should only be determined by an extensive process that assesses your capacity for risk, cash flow and liquidity needs, and other factors. Discuss any portfolio decisions with a financial advisor before making a move.
Have a good financial plan in place: keep your eyes on your long-term goals. Discuss with your financial advisor how to best manage any impact from purchasing power erosion caused by inflation. Your financial plan is your first defense, as it provides a blueprint for financial decisions, both in your personal budget as well as investment portfolio.
Ellen Li is a partner at Financial Alternatives and a lead advisor for many of the firm’s clients and has a special focus on financial planning. Ellen has an MSBA degree in Financial and Tax Planning from San Diego State University and she holds the CERTIFIED FINANCIAL PLANNER™ designation. She is a member of the Financial Planning Association (FPA).
Sources
Dimensional. Dimensional Quick Take: Gold Hasn’t Been Effective at Tracking Inflation. Annual US Inflation Rate vs. Change in Gold Price. https://my.dimensional.com/dfsmedia/f27f1cc5b9674653938eb84ff8006d8c/152279-source/gold-hasnt-been-effective-at-tracking-inflation-quick-take.pdf
Dimensional. Will Inflation Hurt Stock Returns? Not Necessarily. https://my.dimensional.com/dfsmedia/f27f1cc5b9674653938eb84ff8006d8c/70603-source/will-inflation-hurt-stock-returns-not-necessarily-us.pdf
Dimensional Video. Is higher inflation bad news for stock returns?
https://my.dimensional.com/videoframe/140387/does-higher-inflation-hurt-stock-market-performance
Frick, Walter. (23 December, 2022). What Causes Inflation?. Harvard Business Review.
https://hbr.org/2022/12/what-causes-inflation
Leith, Lawrence. December 2023. Bureau of Labor Statistics. Monthly Labor Review. What caused the high inflation during the COVID-19 period? https://www.bls.gov/opub/mlr/2023/beyond-bls/what-caused-the-high-inflation-during-the-covid-19-period.htm
Rascoe, Ayesha, and Selyukh, Alina. (31 March, 2024). NPR. It's not your imagination — chocolate has been getting more expensive. https://www.npr.org/2024/03/31/1241888350/its-not-your-imagination-chocolate-has-been-getting-more-expensive
U.S. Department of Labor. (12 June, 2024.) Bureau of Labor Statistics. Consumer Price Index, May 2024. https://www.dol.gov/newsroom/economicdata/cpi_06122024.pdf
US Inflation Calculator. Current US Inflation Rates: 2000-2024. https://www.usinflationcalculator.com/inflation/current-inflation-rates/