There is a popular character trope--perhaps more appropriately called a popular American character trope--of the immigrant with small means. Arriving in America with almost nothing, the immigrant resolves to pursue the American dream. They find work, earn what they can, and somehow manage to save a little. Over the years their dutiful, disciplined savings goes into a coffee can or small box. Eventually they buy something meaningful, like a gift to their children or the chance to finally get ahead. It is a beautiful sentiment that resonates with those who believe America is a place of opportunity.
That said, it drives the financial planner in me absolutely nuts.
These poor, well-intentioned immigrants (or anyone saving money like this) were essentially pouring their money into a coffee can that might as well have had a hole in the bottom. Imagine the 1970s. Over the course of that decade, a dollar literally fell in value by over 50%. Inflation ate away at the value of those hard-earned savings. What an uphill battle! It breaks my heart to think of how difficult it is to save when compound interest is actually working against you.
There is also a related, famous stereotype of older generations burying cash in their backyard, stowing bills under their mattress, or socking money away in random places for safekeeping. More sophisticated versions of this might be parking excessive money in bank accounts, savings bonds, or CDs. The thought is that the money is at least “safe”.
While I am a believer in having cash on hand for things you may need on short notice, and of course I use bank accounts as well, these alternatives to the coffee can are not that different. Most savings bonds and bank accounts pay meager interest rates. Meanwhile, inflation has flared up! The annual inflation rate for 2021 so far has surged to 6.2%--which means this “safe money” might as well have mice nibbling on the dollar bills. While typical annual inflation in the US is historically around 3%, even that number will eat away at someone’s savings unless we find ways for our money to grow at least as much.
So, what can we do? We have many clients asking what they can do to combat inflation without taking on too much risk--especially when equity markets are at all-time highs and interest rates are at all-time lows.
Many of our clients who need money soon (a couple years or less) might use shorter duration bond funds, inflation protected securities, ‘market neutral’ funds, or other investments that attempt to minimize downside risk. These types of securities typically don’t exhibit the returns of equities (stocks), but they usually have less volatility and still enough of a return to beat back inflation. It is still worthwhile to hang onto some cash for immediate needs over the next few months, but the rest will serve you better collecting interest. We are effectively sealing the bottom of that coffee can. It may not be water tight, but close enough.
For those with longer time horizons for their money, equities typically outperform inflation over time by a larger margin. Companies that consistently raise their dividend can be especially effective in a high inflation environment. Some investors also turn to real estate, often in the form of real estate investment trusts (REITs), during inflationary periods. Real estate rents and prices tend to increase when inflation does, which is why some investors refer to REITs as an “inflation hedge”. Still other investors insist that owning tangible assets like gold, commodities, and other precious metals is the answer. By combining multiple solutions in the right quantities, we can smooth performance and reduce different types of risk while staying ahead of inflation.
That said, inflation is not all bad. In fact, some inflation indicates a healthy economy. The Federal Reserve even has a goal of inflation each year. Inflation is also great for those who have debt, such as a mortgage or student loans, because the real value of debt falls by the rate of inflation. The problem is when inflation becomes too high. Inflation over the last few years has been relatively muted. The dramatic increase this year is largely thanks to stimulus packages and government spending due to COVID. While quite a bit above the Federal Reserve’s goal for inflation, the resulting economic recovery has justified temporarily high inflation levels.
For investors, the answers to inflation concerns tend to be smart financial choices even when we disregard inflation. Allowing money to work for you, balancing risk with potential return, and keeping a long term perspective where possible tends to be the smart (if boring) answer.