Key Takeaways
- Inflation can erode your retirement savings, reduce your purchasing power, and increase your cost of living.
- To keep up with inflation, devise a budget to keep track of your expenses and review it regularly.
- Review your investments at regular intervals and meet with a financial professional if you feel like you’re falling off track.
- Diversify your holdings to include a mix of stocks, bonds, and alternative investments to help you spread out any inflationary risks.
- A consistent, disciplined approach can help you preserve your capital and grow your wealth.
Inflation is the increase in prices of goods and services in the economy, which decreases your purchasing power. If you’re saving for retirement, it’s important to know that inflation can erode your retirement savings, making the amount of money you have today worth less over time.
How Inflation Impacts Your Savings
Inflation causes prices to rise over time. It impacts everything you pay for, including groceries, health care, gasoline, clothing, and housing. Inflation comes with a few risks:
- It reduces your purchasing power: With inflation, as prices rise, you can buy less than you previously could. So when you retire, your savings will only take you so far. Your savings may not cover the expenses you planned for.
- It can delay retirement: Inflation can leave you with less purchasing power and not enough savings. This can lead you to stay in your job for longer than you planned, delaying retirement.
- It erodes savings and returns: Money in typical savings accounts tends to lose value over time because interest rates often fail to keep pace with inflation. The same thing can happen to certain fixed-income assets, too.
Budgeting to Protect Your Nest Egg
To fight inflation, you need to now how far your money goes. Setting a realistic budget helps you identify your expenses and adjust your spending accordingly.
Here are a few things you’ll need to do to help you along the way:
- Track your spending: Record every dollar you spend using a budgeting app, spreadsheet, pen and paper, or other budgeting tool. Categorize your expenses.
- Prioritize your needs over your wants: Needs are essential expenses like housing, groceries, transportation, utilities, and insurance. These are things you can’t live without. Your wants are non-essential items such as dining out and vacations.
- Make smarter choices: Consider finding ways to cut back. This may be canceling unused subscriptions and memberships (like that gym you no longer visit), switching service providers, or downsizing, if possible.
- Review your budget regularly: Come back to your budget at regular periods to make sure that you’re still on track. If needed, you may need to make slight adjustments to keep up with inflation.
Inflation-Proof Your Portfolio Through Diversification
Diversification is based on the adage “don’t put all your eggs in one basket.” This means knowing how risk works and spreading it across different assets, so the losses of certain assets are offset by the gains of others in your portfolio.
Stocks
A well-balanced stock portfolio can provide you with a long-term hedge against inflation. First, stocks have growth potential. The S&P 500 has delivered an average annual return of over 10%, or about 7% to 8% when adjusted for inflation. This growth can help your money increase faster than prices rise.
Second, consider investing in dividend-paying companies. These are businesses that return a portion of their profits to shareholders. This means you get a steady stream of income that can help keep pace with inflation.
Next, by owning stocks, you have ownership in real assets. When costs go up, corporate revenues can also increase to compensate for inflation.
Owning stocks allows you to diversify your stock and ETF holdings. This means you can broaden your stock horizons to include different companies and industries. You can also balance between growth and value stocks and add opportunities from international markets.
Fixed-Income
Fixed-income assets provide you with safety and stability. Bonds and other securities pay you interest at regular intervals, which can help you pay your regular living expenses. This gives you a sense of predictability even when markets become volatile.
Certain fixed-income investments can help you even more than others, notably:
- Treasury Inflation-Protected Securities (TIPS): These are U.S. government bonds that protect your principal investment from inflation. You’re guaranteed to receive the principal or adjusted amount, which is increased during inflation and decreased during deflation, upon maturity plus interest at a fixed rate semi-annually, which is calculated on the adjusted amount.
- I Bonds: These government bonds earn you a fixed rate plus an inflation-adjusted rate. Investing in these can give you a simple hedge against inflation.
Another way to mitigate the effects of inflation is to use bond laddering as a strategy. This involves holding bonds with different maturity dates. When they mature, you can reinvest them at current interest rates. These rates may rise during inflationary periods.
Alternative Investments
You can also fight inflation using investments other than stocks and bonds. Real estate values and rental income tend to rise when prices increase, which can generate cash flow for you and your portfolio. If you don’t want the hassle and costs associated with holding property, you can still benefit by buying shares of real estate investment trusts (REITs). These trade on exchanges and trade like stocks.
Commodity prices also rise with inflation. These are the raw materials used to produce goods and services. Precious metals can give investors a boost, especially gold, since its value isn’t linked to a single government or currency. As currencies lose value, gold’s purchasing power tends to increase. You can invest in gold, other precious metals, and other commodities through ETFs, mutual funds, and futures contracts.
Tip
Avoid holding too much cash and cash equivalents in your portfolio so they don’t lose their ability to perform. A 2024 Vanguard study states that how much cash to keep is dictated by time horizon, circumstances, and perspective, but suggests keeping only a small amount of cash for an emergency fund and to cover immediate expenses.
Why Investing Through Inflation Works
If you invest a fixed amount of money at regular intervals, you take advantage of dollar-cost averaging (DCA). Spreading out purchases allows you to smooth out any market volatility. When prices are low, you end up buying more shares, and when prices rise, you end up with fewer shares.
Consistent investing also gives you tax advantages. Using tax-advantaged accounts, such as employer-sponsored retirement accounts, traditional and Roth IRAs, and health savings accounts (HSAs), can lower your tax liability. Long-term investing gives you preferential capital gains tax treatment if you sell your investments for a profit after holding them for more than a year.
Don’t forget to come back to your investment plan and make regular adjustments at regular intervals, the same way you would with your budget. It may be best to work with a financial professional who can help guide you in the right direction, especially when there’s a lot of noise in the markets.
The Bottom Line
Inflation can be a big threat to your retirement savings. But with the right amount of planning, you can protect yourself against inflationary risks. You can keep money safe and help it grow by budgeting, diversifying your holdings, saving consistently, and readjusting your portfolio at regular intervals.