We are all too familiar with inflation!
Inflation is the increase in the price of goods and services.
For example, if inflation is 5% then what we purchased a year ago for $1.00 will now cost $1.05. When we are planning for retirement we have to consider inflation. The agony is trying to estimate what it will be over our working career and through retirement.
There is no silver bullet to determine what inflation will be in the future. Alternatively, we rely on forecasts by economists and their computer modeling, built on historical data that predicts future expectations. However sophisticated the process may seem, Fed chair Jerome Powell has referred to it as “navigating by the stars under cloudy skies”.
These forecasts play a critical role when making investment decisions, but they are not precise.
Aim for tomorrow!
The primary aim of investing is to overcome the impact of inflation.
We refer to this as the real rate of return, or the return that exceeds inflation.
For instance, if inflation stands at 2% and our investments are projected to return 5%, the real rate of return is 3% (5% – 2%). It’s how much we get to keep after inflation takes its bite.
Another way of thinking of it is inflation is as a headwind. To overcome a headwind (inflation) the force (the return on our investment) must be greater than the headwind. Another example, the propulsion of a jet engine must be greater than the headwind or the jet will stall out. Not a good outcome! Investing is no different.
As depicted in the chart, we’ve experience fairly stable inflation except for the global financial crisis in 1987, the near collapse of the entire financial system in 2009 and the most recent, supply chain disruptions in 2023.
Knowing events will recur over time, we must be diligent to align and adjust our expectations and investment strategy accordingly.