How Rising Prices Can Lower Your Wealth (And What To Do About It)

When AMC, the giant U.S. theatre chain, announced they were re-opening in late August, they decided to lure customers back with a one-day promotion: tickets would only cost 15 cents, the same price as they did back in the 1920s when the company was founded.

Upon hearing this, you might imagine yourself living in that decade. With prices so low, you could go to six movies a year and not even pay a dollar. What a deal!

Or would it be?                                                                                                                                                              

The problem with thinking only in nominal terms is that it doesn’t take into account inflation. Sure, a movie cost 15 cents back in the 1920s, but wages were much lower, too. In other words, workers’ earnings were dramatically lower, so it’s not like going to the movies was actually a bargain for them.

Investors Need to Deal with the “Real” World

As investors, it is critically important that we think in “real terms”, i.e., adjusting for inflation. To use a simplified example, if your portfolio grows by 5% on a nominal basis, but inflation is 7%, the real purchasing power of your portfolio has actually decreased by 2%.

Your goal should always be to maintain and grow your wealth in real terms over time.

Guarding Against Inflation

Ok, so beating inflation is crucial. But how should your portfolio be constructed with this in mind?

Equities, for one thing, have a big role to play. Going back a number of decades, a significant portion of the (nominal) return from equities is really just keeping up with inflation. In one study of U.S. equity returns from 1975-2009, inflation accounted for 4.2% of the total annual growth of 11.4%. That’s well over a third of the gross return.

What about fixed income?  If inflation is fairly low for an extended period of time, bonds can perform very well. We’ve definitely seen this going back to the 2008 financial crisis. With inflation low and trending lower, interest rates have continued to decline.  Bond prices have rallied, given that they are inversely correlated to interest rates. In addition, bond investors have not seen inflation eat into their returns.

Ah, but what if inflation were to emerge in a big way? This is a big risk that a bond investor faces. Whereas equities provide some shelter from an inflationary storm, bonds generally offer no such protection. A bond earning 3% interest looks great at 1% inflation, but decidedly less attractive with inflation at 5%.

Investors can adjust their fixed income portfolios to hedge against the possibility that today’s low inflation rates won’t last. One way to do that, as we talked about in a previous post, is to increase the risk tolerance of your fixed income holdings somewhat. Rather than owning government bonds, for instance, you can own investment-grade corporate bonds that pay a higher rate of interest. This offers some cushion against an unexpected rise in inflation.

It’s not as attractive as the thought of regularly buying 15 cent movie tickets, but then again, we do have to live in the “real” world.