Inflation- How it affects your financial plan and what can you do to protect yourself?
Rising inflation is making financial planning more important as Canadians have to make difficult choices with their spending as inflation eats into the affordability of almost everything we buy. Sam Ewing summed it up best when he said, “inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair”.
What is inflation?
In simple language, inflation refers to the general rise in the price level of an economy over a specific period of time. Essentially it can be an uncontrollable weed taking over your financial future and purchasing power making you poorer day by day.
What are some types of inflation?
The main drivers behind inflation are supply and demand including a shift away from equilibrium.
Demand pull inflation is driven when total demand in an economy exceeds the total supply.
Cost-push inflation is when total demand is unchanged but supply declines due to external causes.
Typically, when prices rise in a stagnant economy, this is referred to as stagflation. This was present in the 1970s when the United States abandoned the gold standard.
When governments resort to the uncontrollable printing of money this typically produces hyperinflation. Prices can grow by more than 50% in a month from the increase in the money supply.
Wage inflation is when workers’ pay rises faster than the cost of living. This kind of inflation occurs when there is a shortage of workers, labor unions negotiate ever-higher wages, and when workers effectively control their pay.
How does inflation affect your financial plan?
When modeling financial planning projections for a retirement plan a constant level of inflation is assumed over the entire span of the plan. Moreover, the growth rate on investments is also assumed constant over this same period of time. If it rises rapidly over the span of the plan it will drive up your expenses and deplete your investments faster. This effect will be compounded if you have defined benefits pension plans that are non-indexed. In the end you run the risk of running out of money in your golden years.
Top 3 things you can do to protect yourself against inflation
Stay invested, avoid being in cash or short-term cashable investments. More specifically, own stocks in your portfolio that have strong balance sheets, cashflow/profit growth, and pricing power. This will drive dividends and share prices to grow.
Own real estate as it can be a great hedge. if you own rental real estate, you may get rising rents in an inflationary environment. That ability to increase your future cash flow gives you an inflation hedge on your cost of living.
Lock in the price of your expenses and avoid acquiring things with disruptions to supply that are causing a temporary spike in prices. Fixing the interest rate on your liabilities is a good way to hedge because you are no longer subject to rising expenses.
With the potential of inflation in the economy you are encouraged to work with a professional financial advisor to mitigate any risks to your financial future. Moreover, a solid financial plan that is reviewed on a regular basis is an excellent tool that can be used to prepare you from any pitfalls.