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Inflation and Financial planning: The effect of inflation on your financial future
Inflation is a major factor in the realm of personal finance; it’s a risk that affects investment positively or negatively. In broad terms, inflation is the general increase in prices because of a change in the money supply or the availability of goods. It is not merely a macro-economic concept, since it is relevant to the finances of individuals in four primary ways:
- Determining the real return of an investment
- Evaluating the purchasing power risk
- Interest rates for savings
- Effect on financial instruments
The Great Super Cycle: Profit from the Coming Inflation Tidal Wave and Dollar Devaluation looks at what we can expect in global economics by looking at the history of political shifts in power. The underlying theme is that everything moves in cycles—from the mega-cycle of world powers, to economic cycles that can last decades, to mini-cycles that last ten to twenty years.
The real return of an investment
This concept refers to the discounted nominal interest rate (rate after inflation is discounted). In the realm of investment, this effect is referred to as inflation risk. Although this risk has a significant effect on investors, the combined risks of taxation and inflation are far more serious than inflation risk on its own. A good example is the treatment of deferred annuities, where tax is paid on annuitized payments and the payments are typically fixed. Even after discounting for inflation, tax must be levied against the accumulated nominal returns (and not the discounted one – unfortunately). The real return is further eroded by the effect of inflation on the payments received.
Purchasing power risk
Inflation is also influential in this aspect of investment risk. The loss of purchasing power on investment returns is tied to the reduced purchasing power per dollar. Purchasing power risk affects the capital invested significantly. With low-yield investment instruments, the purchasing power of the principal declines rapidly.
In macro-economics, there is a link between inflation and interest rates; a link that filters down to the individual. One of the methods of controlling inflation is to increase prime lending rates in an attempt to discourage borrowing. High interest rates also make investing more attractive than consumption, which reduces aggregate demand in the economy.
Interestingly, inflation is not always a bad thing. Certain financial instruments benefit from high inflation. Usually these are the types of investments that have intrinsic value, because such assets remain in high demand regardless of the level of inflation. Examples of such assets include art, real estate, gold and other commodities. High inflation increases the absolute returns on such investments. Notice that the opposite happens with regard to cash/income instruments like savings accounts and money market funds. When inflation is low, it is less risky to invest in cash and income options.
While many persons who are risk averse are afraid to “lose,” inflation causes real loss for the ultra-conservative investor. Portfolio diversification is not only important in managing market risk, but can also mitigate inflation risk. While limiting investment in growth options reduces market risk, increasing investment in them reduces inflation risk. It is a trade-off that emphasizes the delicate balance of diversification. Such information can only redound to the benefit of a prudent investor.