Inflation Hurts – Inflation & Your Portfolio—10/03/08

INTRO: Here’s a riddle for you – when does “more” actually mean “less?”  The answer? When we’re talking about inflation!  You can feel it -- Inflation leaves less money in your pocket. But there’s “more” you can do to “less-en” inflation’s effects on your long term investments.  

1.  THERE’S A GREAT DEAL OF TALK ABOUT THE ECONOMY THESE DAYS, BUT WE DON’T HEAR THAT MUCH ABOUT INFLATION.  IS IT NOT A PROBLEM?

A. The historic norm is 3%.

B. Current inflation is running around 5.4%.

C. That is a significantly above the norm.

2. GIVE US SOME IDEAS ON HOW TO “INFLATION-PROOF” OUR PORTFOLIO.  LET’S START WITH STOCKS.  HOW DO STOCKS DO WHEN INFLATION INCREASES?

A. Stocks have the potential for growth.

B. Companies with large fixed costs can benefit in times of inflation.

• Their fixed costs don’t increase but they can increase their prices, improving their profitability.

C.  However, other companies or industries may not do as well.

•  If they have increasing material costs – and can’t pass the costs on to the consumer because of competition – their profit margins can really take a hit.
• EXAMPLE: Think of the airline industry – their wings have been clipped!  Fuel costs have skyrocketed, but hey haven’t been able to pass all of these costs onto consumers.

D. Also, larger consumers can have more of a cushion to weather the storm?

3. WHETHER YOUR STOCKS SURVIVE INCREASED INFLATION DEPENDS ON THE KIND OF COMPANY YOU’VE INVESTED IN AND HOW THEY CAN WEATHER INFLATION.  ARE BONDS A BETTER INVESTMENT WHEN INFLATION IS AN ISSUE?

A. For those in retirement, bonds, in general, are an important part of your portfolio.

• Bonds create a steady income stream that replaces the pay checks that ended with retirement.

B. However, the interest on a bond is not indexed to inflation.

• Bond interest does not increase as time goes on, so you get locked into the interest rate of your bond at purchase time.
• Purchasing power is lessened because of inflation.
• EXAMPLE:
  1. $1000 bond with 5% coupon – matures in 10 years.
  2. Today, income will buy $50 worth of goods and services.
  3. In ten years, you’ll get the same $50 in interest – but it won’t buy the same amount of goods and services as it did in 2008. 
  4. And, when the bond matures, you’ll receive the face amount of $1000 but, since it’s not indexed to inflation, you’re being repaid in deflated dollars – it just won’t buy as much.

4. OKAY, STOCKS ARE IFFY, BONDS WON’T BUY AS MUCH WHEN THEY MATURE – SO, WHAT’S THE ANSWER?  IS THERE AN INVESTMENT THAT OFFERS PROTECTION FROM INFLATION?

A. Yes.  They’re called “Treasury Inflation Protected Securities.”

• With “TIPS,” you receive stated interest.
• At maturity, repayment principal is adjusted for inflation.
• EXAMPLE:
  1. $1000 investment
  2. Inflation rises 30% over ten years
  3. Principal repayment - $1300

5. ARE THERE ANY OTHER BONDS THAT OUR VIEWERS SHOULD CONSIDER INVESTING IN?

A. Yes. The Treasury also offers Series I Bonds that help savers combat inflation.  Interest on bonds has two components 

• Fixed rate set for life of the bond
• Inflation rate that changes every six months
• Since May 1st, the fixed rate has been 0% (is this right?0 and the inflation rate has been 4.84%.
• I Bonds have a five year maturity.

6. ARE THERE ANY OTHER INVESTMENTS THAT HAVE SOME PROTECTION AGAINST INFLATION?

A.        Other issuers of fixed income securities now offer some mutual funds and exchange traded funds that invest in inflation protected securities.

B.        It’s best to look at your overall portfolio and to remember that inflation is just one of many factors you should consider when evaluation investment alternatives.