Your Best Rate of Return Might Be In Your Budge

Remember the 70’s when we were faced with double digit inflation? Those were painful times for a lot of people. Other than rising health care costs and college tuition, we haven’t paid much attention to inflation over the recent past because it has been relatively moderate. Things have changed; with energy costs, grocery prices, and everything else going up in cost, more attention is being paid to inflation. In August the U S Labor Dept. released the latest numbers showing inflation running at around 5.4%, which is substantially higher than the historic norm of 3%.

If your income increases at a rate exceeding inflation, your monthly budget isn’t getting squeezed. But if inflation is greater that the increase in your wages and other sources of income, Ouch! Inflation hurts! Are you on a fixed budget? That could mean ouch now and for years to come!

I look at savings in my living expenses as I do the return on an investment. If I can save 10% by being an educated consumer, I look at that as a 10% rate of return. You can’t control all of your living expenses; unfortunately some of them are fixed. But if you can save 5% on your living expenses on average, it will probably add up to more than you think. Let’s look at an example to put this idea in perspective.

Say your monthly living expenses are $2000. By saving 5% that equals $100/month, or $1200/ year. As you can see, 5% may not sound like much but over the course of a year it adds up. Wouldn’t it be nice to have an additional $1200 in your pocket? That would cover ½ of a month’s living expenses!

What about the impact of inflation on your savings and investments? You have saved and invested for the long haul, and inflation can have a significant impact on your portfolio over the long haul. How do you help protect your portfolio from the impact of inflation? Here are some ideas.

Let’s today look at two general assets classes and how they cope in periods of inflation. Armed with this information you can begin to review your own portfolio to see if it is inflation proof, or if it needs attention in this current period of above average inflation.

Stocks have the potential for growth. As companies face increasing material or labor costs they can pass these increases onto their consumers and maintain their margin of profitability. Companies with large fixed costs can really benefit in periods of inflation. Their fixed costs don’t increase but they can increase their prices, improving their profitability. But not all companies and their stocks benefit in periods of rising inflation. If a company or industry is facing increasing material costs, but due to competition cannot pass these costs onto the consumer, their margins can be drastically damaged. Think of the airline industry. Their fuel costs have skyrocketed, but haven’t been able to pass these costs onto consumers.

For many investors, especially those in retirement, bonds serve a great need in their portfolios. Bonds create a steady income stream that replaces the pay checks that ended with retirement. But bonds have historically not been a good hedge against inflation. The interest on a bond is not indexed to inflation; it does not increase as time goes on and the purchasing power of the income is reduced because of inflation. Lets say you have a $1000 bond with a 5% coupon1 that matures in 10 years; today the income will buy $50 worth of goods and services. In ten years, assuming you still own the bond, you will still get $50 in interest, but it won’t buy the same amount of goods and services it did back in 2008.

Likewise, when the bond matures you will get your face amount, $1000. But it will not buy $1000 worth of goods and services because your principal isn’t indexed to inflation. You are being repaid in deflated dollars. If inflation were to be 3% over the ten year period you held this bond, you would get repaid in dollars that would only buy about $700 in goods and service.

Inflation is just one of many factors you should consider when evaluating investment alternatives. You cannot overlook other considerations including risk, income needs, and taxes just to name a few. Your portfolio should be constructed with the needs and constraints of your individual situation.

1 This 5% coupon is for illustrative purposes only and is not indicative of any particular fixed income investment; your results will vary.

Lineweaver Financial Group, 9035 Sweet Valley Drive, Valley View, OH 44125 Phone1-888-313-4009
Securities offered through Sigma Financial Corporation. Member FINRA/SIPC.