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Inflation is one of those economic terms most of us know just enough about to be afraid of. We know it erodes our money over time, and that it arrives in the form of higher prices for everyday goods and services. Inflation fears can also lead to negative reactions in the stock market, such as the selloff in May. But according to experts, this may be the wrong reaction to inflation news.
But first: What factors are driving these inflation fears? Plenty.
“There are definitely inflationary signals, no doubt,” says Aleksandar Tomic, an economist and associate dean of strategy, innovation and technology at Boston College.
In May, the consumer-price index, which measures the average cost of goods around the country, saw a year-over-year increase of 5% — its largest jump since August 2008. This comes on the heels of April’s CPI numbers, which came in much higher than economists had predicted.
“Everybody was thinking it would be 3.6%, which would have been significant given that we’re running around 2%,” Tomic says of April’s CPI report. “The numbers were significantly above expectations.”
COVID-19 relief measures pumped cash into economies all over the world, Tomic says. Those relief measures gave consumers the power to buy at a time when supply was constrained by several factors, including pandemic-hobbled businesses, worker shortages and the Suez Canal blockage.
See: Inflation is surging. How high will it go? Check out MarketWatch’s new tracker
And by May, there were even more signs of inflation. Bureau of Labor Statistics data showed job openings and the number of people quitting their jobs in April were both at their highest levels on record.
“So there’s a lot of activity, a lot of searching for talent and a lot of confidence, which is why they’re quitting jobs,” Tomic says. “And sooner or later, the wages will start rising.”
If April’s report started the discussion about impending inflation, it appears May’s report bolstered it even further.
“This time, inflation is coming from all sides,” Tomic says.
But here’s the kicker: Despite all this, long-term investors needn’t actually fear a surge in inflation — as long as they’ve set up a healthy investment portfolio.
Why experts say you shouldn’t sell on inflation fears
When there’s a whisper of rapid inflation, the market may react by selling. On May 12, when the Bureau of Labor Statistics released the surprisingly high consumer-price index data, the S&P 500 saw its worst three-day drop in almost seven months. But why?
“The market always sells first and asks questions later,” says Tiffany Kent, a certified financial planner and portfolio manager of Wealth Engagement LLC in Atlanta.
In this instance, she says the potential for higher inflation scared investors because when inflation rises, interest rates may rise too. And when interest rates rise, it’s possible that company profits could be negatively affected, which could cause their stock prices to drop.
So traders decided to sell in the moment, then spend their time analyzing what it all meant later.
Most individual investors — especially those new to the market — wouldn’t do well taking that same frenzied approach, Kent says. Unless you’re versed in the traditional ways of measuring how valuable a company is, such as analyzing its price-to-earnings ratio, you’re more or less trading on hope.
“And it’s hard to invest in or bet on a hope,” she says.
The better option? Keep your money parked in stocks rather than selling in a panic or trying to time the market, says Matt Canine, a certified financial planner and senior wealth adviser with East Paces Group in Atlanta.
“Historically, stocks in general are the highest returning asset class and are the best hedge against inflation,” Canine says. “That’s one thing we want to impress on people. If you’re currently invested in the market, you’re probably going to be OK.”
And if you’re a younger investor, this advice is especially pertinent, says John Pilkington, a certified financial planner and Vanguard wealth adviser executive in Charlotte, North Carolina.
It’s possible a large uptick in inflation could drive a negative reaction in the markets, Pilkington says, but young investors have the most to gain by staying put.
“If you’re a long-term investor, stocks are still likely your best long-term response to inflation,” Pilkington says. “So I think you have to take a long view with your investment portfolio, and there’s really no group that’s better poised to do that than someone who is starting out in their 20s or 30s and putting away for retirement.”
Whose investments could be impacted by inflation?
Even after May’s report, economists still aren’t sure if the higher prices we’ve seen this spring are a temporary blip or a sign of more sustained inflation. But if it’s the latter, Pilkington says, there’s one group (from an investment vantage point) that might be hit particularly hard: retirees on fixed incomes.
To understand why, look at an example with bonds, a common fixed-income investment among retirees that pays the investor specified interest over time. Higher inflation means investment returns have less buying power, so the goal is for those returns to outpace inflation. If your bonds are paying 3% interest before inflation, and inflation is rising at 2%, your real return is 1%. However, if inflation is rising at 4%, you’re getting a negative return, once adjusted for inflation. In other words, your money may be growing, but you’re still losing buying power.
Read: Here is where higher inflation really hurts, says world’s largest asset manager
So what’s a recent retiree to do if they sold a large portion of their stocks for any reason, perhaps converting them to inflation-sensitive bonds as part of their retirement plan, just as inflation fears ramp up?
Kent says she’s had a lot of discussions with clients who are in that exact position. And even though she believes it may be a good option for them to get back into stocks, she says it can be hard to convince them of it. Stocks tend to be more volatile than fixed-income assets, and retirees often favor stability.
But there are responsible ways to go about it, Kent says. Chief among them is a method that works for younger investors and retirees alike: dollar-cost averaging, in which you invest small amounts on a set schedule over a long period of time.
“It’s a very logical approach to getting back into the market,” Kent says. “We know that we can’t time things perfectly.”
Kent is currently recommending her clients spread their contributions out over two years if they recently sold their stocks but are getting back into the market.
By investing small amounts over a long period rather than putting it all back in the market at once, Kent says, retirees can limit their risk due to market swings and have cash ready on the sidelines to buy in at low prices if there’s a downturn.
The case for a financial plan
Among financial planners, there’s a widely shared sentiment: Inflation, whether temporary or sustained, is a natural phenomenon that any good financial planner will account for.
Also on MarketWatch: Will millennials have enough money to retire?
And according to Pilkington, it’s one of the three biggest drags on a portfolio’s performance, alongside expenses and taxes. So if you can build a portfolio that’s low-cost, tax-advantaged and highly diversified, that’s how you protect your returns from inflation, and how you keep the majority of your money over time — no matter what’s happening in the markets or broader economy.
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Chris Davis writes for NerdWallet. Email: cdavis@nerdwallet.com.
