Is your net worth built to survive inflation?

Two big factors that can impact your net worth are taxes and inflation. In this posting, I want to discuss inflation.

Essentially, the government pumps out a certain amount of money periodically. The Big Idea behind this is to smooth things out by having a steady increase in money supply. You can debate whether this works or not in some other forum. I only want to discuss how this impacts your net worth.

If your money is invested in fixed instruments like treasury bonds, CDs, or fixed interest bank accounts, then inflation can be very hard on your net worth. A pile of cash can lose its purchasing power when it grows at 1% (or less) while inflation grows at 3-4%. Inflation is a complicated concept. There are a couple of ways to look it up. One is the base rate that the Federal Reserve lends money to banks. Since banks make money by adding a little profit on top of this, all other interest rates are above this. Given that you can borrow money today at rates like 3.5%, you can imagine how low the Federal Reserve rate is.

Another is called the Consumer Price Index (CPI). The CPI is essentially a basket of goods whose purchase price is tracked periodically. As the prices rise, an estimated rate of increase is derived, i.e. inflation. But going back 20-30 years, we find that this basket of goods has been altered on multiple occasions. For example, in recent years, beef and oil have been removed from the CPI. Official inflation metrics may report somewhere in the neighborhood of 4%, but the price of beef has risen much faster than that in recent years.

Suffice it to say, the subject of inflation can be talked about to death. But it’s real and here to stay. Which means we must deal with it when it comes to retirement investments. Take a real example. Imagine you own a home and need to replace the roof. If you do it right now, there is a certain cost. What if you need replace the roof again 25 years from now when you are retired? The price will have certainly risen. Other home maintenance costs will slowly rise as well. Fixed income instruments don’t lend themselves well to handling this rise in home repair costs. Other things that increase in cost is groceries, medicine, and gasoline. All these things are good you will need in the future when you are retired. Simply paying off your home mortgage won’t shield you adequately from needing to deal with this.

Assets that weather the storms of inflation

Some tools we use for investment purposes are ravaged by inflation while other things tend to compensate. One asset that can handle inflation is rental property. In times of inflation, rents tend to rise along with the value of the property itself. They may not grow at the same rate, but generally, rents rise. Now in past articles, I have presented numbers on the value of real estate based on NO rent increases. That was to make sure things were sound without depending on these increases. Sometimes rent doesn’t increase when inflation grows. Or at least it might not rise immediately. But in the long run, and real estate is a long term investment, rents rise and that’s a good thing.

Do you know what else weathers inflation pretty well? Dividend aristocrats. These are long term companies that have been paying increasing dividends over decades, some more than 50 years. These are from companies that are producing quality goods that are able to raise the prices of their goods in line with inflation. By owning positions in some of these companies, you can keep receiving increasing dividend payments that tend to compensate for inflation.

The strategy to building up an inflation-proof plan

Okay, that headline is misleading. Nothing is inflation-proof. Maybe inflation-resistant. Every time this country has suffered high levels of inflation, the reasons have varied. Some people think we are poised to enter a high level of inflation, or even hyperinflation. I’m not sure I agree with that. Those opinions have to be counterbalanced by whether the ones making the boldest predictions are selling.

To get this conversation on track, the question should be, what strategy must I use to handle future inflation?

  1. Develop a good reserve fund. This is where I agree with the many pundits who are talking about building up a 6-12 month reserve of liquid cash, like in a savings account. 
  2. Eventually, owning a home with a fixed-rate loan is a good thing. While property taxes and homeowner’s insurance may rise, a fixed payment of debt will tend to shrink as inflation grows. This also helps you avoid rising cost of rents. It’s no reason to buy a home RIGHT NOW before having your cash reserve built up, but eventually, a fixed house payment will help reduce the risk of being on the wrong side of rising rents (your own rent!)
  3. Start acquiring cash flowing rental properties and dividend paying stocks. As dividend payments come in, reinvest them periodically, and as extra rent comes in, use it to pay off investment debt.
  4. Plan to increase your inputs in various investing vehicles each year to compensate for lost power of the dollar.
This list, while seemingly detailed, is very non-specific on when to do each, or how much time it should take, etc. That’s because everyone is different. You can send me a note if you want to chat a la email, skype or on the phone to talk about things in more detail. There are no promises to be made when it comes to dealing with inflation, but certain approaches are better than others. The bottom line is that investing in real estate and cash yielding stocks are good tools that have a long history of helping to compensate for inflation. Both of these things are better than gambling on mutual funds being able to match or exceed inflation through the pure appreciation of mutual funds.