How inflation affects your portfolio, and what you can do about it
Inflation is the phenomenon of rising prices. It cuts into people's buying power - a real problem for retirees living on a fixed income, many of whom can't make up the loss by earning more money. If inflation catches up with your investments while you're saving for retirement, it can blow your plans off course. What causes inflation? And what can you do to stay ahead of it?
Inflation, at its most basic, has two causes. First is rising costs for such items as raw materials, wages, employee benefits and transportation that make it more expensive for companies to supply their products and services. For example, in the 1970s, when oil-producing countries boosted the price of crude oil, the results were overnight price increases and inflation in the double digits.
The second factor occurs when the amount of money people have to spend increases faster than the supply of goods and services they want to buy. For instance, during the 1980s, home prices skyrocketed when the huge baby boom generation decided it was time to buy homes.
All of this has important implications for your retirement savings plan. Inflation is a crucial factor in how your investments perform. The expectation of higher future inflation causes long-term lenders, such as bond buyers or bond fund managers, to demand higher yields (interest). Their reason is that their money will be worth less when they get it back, so they require more interest to make up for that. An expected inflation drop produces the opposite effect.
Inflation affects other types of investments, too. The stock of companies that can't offset rising costs with higher prices is likely to fall. On the other hand, the share prices of companies that grow more rapidly than inflation may go up. The interest rate for money market funds is likely to go up as inflation rises, but tends not to surpass inflation by much.
To avoid the effects of inflation, choose investments with the potential to match or exceed the inflation rate. An RRSP portfolio composed only of safe investments, such as government bonds, may sound like a smooth ride, but it can run out of gas. If inflation averages 4% a year, and your money is invested to receive a guaranteed 3% annual return, you actually lose 1%.
So what's the best way to shield your retirement portfolio from inflation? You won't always be able to accurately predict and outrun inflation. But periodically ask yourself if, over time, your investments are on track to earn enough to stay ahead of the expected inflation rate. Diversify your portfolio - and keep an eye on your rear-view mirror to make sure the inflation tornado isn't gaining on you.