Inflation typically refers to an economic environment in which prices are increasing and the purchasing power of your money is decreasing. If you pay attention to financial news media, inflation is referenced near constantly, but there’s typically arguments on all sides about whether or not to expect increasing inflation. Today, in early 2021, interestingly, it seems we’ve reached near consensus that higher inflation is coming.
Inflation is measured in a few different ways. Officially, the government measures inflation using the Consumer Price Index (CPI) which looks at price increases/decreases of a basket of goods. Unofficially, us members of the public measure inflation through our personal experiences. We see higher home values on Zillow. We see higher grocery bills. Our gas prices at the pump are higher.
It can be confusing when we see higher prices for normal, everyday items, but meanwhile the government is telling us that there is no inflation via a mundane CPI report.
For me personally, I recently went to a “Five Guys” burger location in my mid-tier city and got a bacon cheeseburger, fries and a drink. I was shocked when it rang up to over $18! What in the world?! Inflation, no? Almost $20 for a fast food meal for one seems absurd.
The Federal Reserve has made it clear that they intend to run the economy a bit more “hot” than typical in order to help aid the post-COVID recovery. So again, inflationary pressures seem like they’re coming. We’re not here to debate policy, but we’re here to discuss the implications of such an environment on our personal finances and investments. And perhaps provide some reminders on how best to navigate the environment.
To properly address the situation, we need to understand what is likely to occur (and is already occurring). Unfortunately, in an inflationary environment, the segment of society that owns assets will often do better than the segment of society that does not own assets. The reason for this is that part of the inflationary environment will lead to asset inflation. The assets you own will go up in price.
Asset inflation will benefit those who own the assets, and there is a degree of downstream benefit to the broader economy as a result (how much is debated).
First, there’s the so-called “wealth effect.” When people feel richer as a result of their investment portfolio or home going up in value, they are more likely to spend money. Secondly, rising asset prices can lead to additional liquidity options that lead to economic activity. One of the most common forms of this is when a homeowner sees the value of his or her home rise dramatically, they will often refinance and pull cash out to fix up the home. This leads to spending at places like Home Depot and leads to the hiring of contractors and workers who do the work. Again, economic activity.
So while some of the gains of the asset owners does indeed “trickle down” and lead to more economic activity and stimulus that can benefit all, it’s important to know that those who do not own assets are often faced with bearing the burden of an inflationary environment. Simply put, a rising cost of living makes people poorer, and those who don’t own assets don’t have the asset inflation to make up for the fact that their groceries, gas and other things are costing more.
I mention this because all of these forms of inflation that we see in the real world have impacts and consequences for our personal finances. With that said, let’s get into some specific reminders and recommendations for navigating an inflationary boom environment.
Home values have been rising for some time. You’ve likely seen this anecdotally in your own neighborhood depending on where you live, and you can see it in the data being reported in the media. While asset inflation in general can be a contributor, home prices have a direct correlation to the low interest rate environment we find ourselves in. As buyers can borrow more due to historically low interest rates, they are able to buy more house for the same level of income and liquidity.
In my part of the world, Central Florida, it’s been a seller’s market for some time. If you want a house in a decent part of town, don’t even think about negotiating because there are going to be multiple cash offers on the first day of listing. It’s bonkers. Prices keep going up.
This environment introduces a few decisions and temptations for individuals. For homeowners, refinancing at a lower rate is available for just about anyone. A refinancing, of course, leads to the temptation to pull cash out while reworking the note on your home. In some cases, due to a lowering of the interest rate, you can pull money out, lower the rate and keep the same payment level.
Those of us who are focused on building wealth should avoid the temptation. Yes, there are times when pulling out cash to make home improvements can make sense, but it’s important to realize that housing is an expense.
Too often, we view our primary residence as an investment when it’s mostly just an expense. How recently you renovated your kitchen has more to do with a lifestyle choice than an investment choice. Sure, you’re improving your resale value, but unless you’re truly downsizing, most people buy a new home for about the same (or more) than they sold the previous home. As such, you aren’t really earning a return on the investment. Instead, any gains you make on the house are just getting funneled into the next home (after getting a chunk taken out due to real estate transaction costs).
If you’re seeking to become a first-time homeowner, resist the urge to keep going higher on how much house to buy just because interest rates are enabling the possibility. Even with low rates, consider a modest purchase. Debt is still debt, and housing is an expense.
An inflationary environment will often lead investors into thinking the whole investing game has become quite easy. Double digit returns year after year, this is easy! The common temptation here is for investors to move further and further out on the risk spectrum as a result of the appearance of easy returns. It’s already happening.
In early 2021, we’re seeing a boom in speculation across a number of asset classes. Whether it is 20-something aged Robinhood users buying call options on stocks like Gamestop (GME) or the recent boom in sports trading cards or the boom in crypto trading, speculation is everywhere right now.
My 75-year old father has a very typical 60/40 retirement portfolio via Vanguard. He recently had an insurance policy expire, and he received the cash value of $100,000 as a result. He mentioned to me that he wants to put that money into something a little more interesting than just sending it to Vanguard for the usual 60/40 allocation. It’s purely a result of seeing others potentially making outsized returns in risky assets. They call it “FOMO” (fear of missing out). I pleaded with my dad to resist the urge. My dad has already won the game. He’s not extravagantly wealthy, but he has a comfortable retirement with enough money to generally do what he wants the rest of his life. Why deviate?
When risk assets are booming, it’s super important to remember to stay the course. Stick with your allocation plan. Rebalance at regular intervals even if it means slight underperformance in the near term (rebalancing typically means underperformance during a period of a raging bull market). Your goals are long-term and the largest gains come in the form of year-after-year compounding. This year-after-year compounding will occur in all sorts of market environments. Don’t be swept up by the boom environment of the present.
The last reminder here equally applies to those of us with assets and those of us without assets. In an inflationary environment, cost of living will typically rise. Things will cost more. It’s especially prudent in such a time to revisit spending plans and ensure you are not overspending.
Savings are the backbone of wealth generation. You can’t earn a rate of return without first saving the money. While finding margin between income and spending might come with an extra degree of difficulty during a period of inflationary pressures, put the work in and give your spending plan a full review.
Recall that the bigger ticket items will move the needle the most. It’s difficult to build savings by foregoing regular runs to Starbucks if you’ve got a $600/month car payment. Start with the larger, fixed expenses and reduce them if possible. Then, give the smaller expenditures a thorough review. Typically, we can always find a few places to cut spending without altering our lifestyle too much.
Time is the most important factor in wealth building for the vast majority of individuals. This means that executing a long-term strategy through a myriad of different economic environments will lead to significant wealth building. Understanding what a possible inflationary boom environment might look like and the potential temptations that might arise during it can help prepare you to navigate the time period without harming your long-term financial objectives.
If you can maintain a focus on the long-term and keep your expenses in check, you can potentially benefit from this inflationary environment.