THE FEDERAL GOVERNMENT recently issued its monthly inflation report. The resulting headlines could have put you to sleep: “Consumer Price Index Rises 0.2% in April.” It would have been easy to skip over this seemingly insignificant story for two reasons: First, the way the government reports inflation data, focusing on the monthly increase, isn’t terribly meaningful. Second, even if you looked at the annual rate, which is 2.5%, inflation just doesn’t seem like much of a concern.
But before dismissing the topic entirely, it’s important to keep in mind a key concept from behavioral finance: recency bias. We place disproportionate weight on whatever we have observed most recently—and these recent events heavily influence how we think about the future.
In certain situations, this isn’t a problem. If a sports team has had a great year, it’s likely to keep winning. If it’s 70 degrees outside today, it’s likely to be approximately the same tomorrow. In these cases, the most recent data can be a useful predictor of what comes next. But when it comes to financial trends, including inflation, it’s a mistake to focus only on recent experience.
I raise this topic because inflation could have a larger impact on your financial future than recent headlines suggest. Since year-end 1989, the average annual inflation rate has been a relatively modest 2.4%. But you don’t have to look too much further back to see that it wasn’t always this way. In the 1980s, inflation averaged about 5.1%. In the 1970s, it was 7.4%, with one year topping 13%.
Why is inflation important to your financial plan? Suppose you are 40 years old and want to spend the equivalent of $100,000 per year when you retire at 65. At an inflation rate of 2.5%, you would need $185,000 per year to provide the equivalent of $100,000 today. But if, in coming years, inflation rose back to its 50-year average of 4%, you would need closer to $270,000 to provide that same spending power in retirement. Assuming a withdrawal rate of 5%, that could mean the difference between a savings goal of $3.7 million and $5.4 million.
If inflation is unpredictable but potentially so consequential, what should you do about it? I have four suggestions:
First, be sure your financial plan incorporates a range of outcomes. In the above example, the gap between $3.7 and $5.4 million is huge. It would be glib to simply say, “Save as much as you can.” Still, you should consider a range of potential outcomes—and have a “Plan B” in case inflation turns out worse than expected.
Second, avoid leaving too much in cash. Even the most generous savings accounts are paying just 1.5% or 1.6% these days. Figure in inflation at 2.5% and you’re automatically losing ground. There are valid reasons to hold some cash, but I would caution against holding a lot of cash for a lot of years.
Third, be careful with fixed-rate bonds, which can lose value when inflation rises. I sometimes hear people refer to bonds as “safe.” But in an environment of rising inflation, bonds are hardly safe. While the stock market’s performance is mixed during periods of higher inflation, you’ll likely be much better off in stocks than in bonds. The reason: When inflation rises, companies can raise prices and ultimately that should flow through to corporate earnings and thus stock prices.
Finally, beware of the myth that gold is an effective hedge against inflation. While it’s true that there have been periods when both gold and inflation were rising at the same time, that isn’t always the case. According to one study, the long-term correlation between gold and inflation is below 0.2—in other words, very weak. As I said to one client recently, if you really want to invest in gold, buy jewelry. That way, at least you’ll get some utility out of it—even if the price doesn’t go up.
Adam M. Grossman’s previous blogs include All Thumbs, Looking Sharpe and Anything but Average. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.