With headlines earlier this year proclaiming the costs of raw materials like steel and wood had risen over 350%, or that housing prices had hit an all-time high, it was hard in 2021 for investors to avoid the topic of inflation.[1]

The fact of the matter is that for much of the year, inflation has been a very real concern. For example, the Labor Department notes the consumer price index was up 5.4% in May of this year versus the same point in 2020. 

While 5.4% may not sound significant, it’s worth noting this is nearly two times the long-term annual inflation rate of 3%. Given the various factors currently driving this rise, it’s quite possible investors may be feeling the impacts of inflation for the foreseeable future.

As such, it’s important investors understand how they could potentially be impacted by inflation, and what steps they can take to help safeguard their own financial well-being.

Breaking it down: What is inflation?

In the simplest sense, inflation is how economists say, “Prices are going up.” While it’s a bit more nuanced than that, inflation is a normal function of the markets.

The long-term inflation rate in the US has been relatively low over the last century. From 1928-2020, prices have risen annually by approximately 3.01%. However, various goods are affected quite differently.

Just think back on the last 20 years. In the year 2000, the average cost of a dozen eggs was approximately $.98. In 2021, that cost is $1.47 – a 50% increase. 20 years ago, the average cost of a gallon of gasoline was roughly $1.30; today it’s about $2.33 – a 79% increase in just two decades.[2]

Obviously, quite a few factors go into these cost increases – rising labor costs, production costs, regulations, innovation, and more – but the point is, inflation is normal and should be expected. More importantly, it generally occurs at a pace consumers can adapt to, often to the point where it’s not generally noticed.

However, inflation was a significant factor in the economy in 2021. While not every investor felt it in the same manner, the fact was inflation rose faster in 2021 than at any other point in the last 30 years. When prices rise, investors have less money to direct toward their portfolios, which in turn can impact their ability to achieve their financial goals.

What contributed to 2021’s rise in prices?

There were a number of factors that contributed to 2021’s sharp rise in inflation. First and foremost was a sense of pent up consumer demand following nearly a year and half of pandemic lockdowns. This was fueled by increased consumer liquidity resulting from government cash payments and enhanced unemployment benefits. Coinciding with this was a bottleneck in supply as global economies struggled to spin back up to speed following 2020’s lockdowns and resulting supply chain shortages. Simply put, there was more money in the economy chasing a smaller supply of goods.

Topping it all off, a change in consumer behavior due to the pandemic – largely impacting the travel and restaurant industries – left certain commodities like used cars and large appliances in short supply as more Americans chose to stay home, drive more and dine out less. As simple economics has shown us, when demand rises and supply falls, prices tend to go up.

How does inflation impact investors?

In the short-term, inflation can lead to volatility in the markets. When the costs of goods and services rise unexpectedly, it puts into question the profitability of companies trading on the market and leads to speculation on the value of their future streams of earnings. This can result in rapid market swings with the potential to negatively impact a portfolio. Beyond that, if housing prices rise 20% and gas prices climb to $5 per gallon, there’s likely going to be a very real strain on your budget, which can put pressure on your ability to save and invest toward your financial goals.

In the long-term, rising inflation means a general increase in the cost of goods and the cost of living, resulting in a decrease in your purchasing power – a dollar today won’t go as far as it once did in the past. 

From a practical sense, this means if your portfolio doesn’t produce returns that outpace the rate of inflation, you’ll experience an overall decrease in purchasing power.

This can be especially challenging for those living off their assets in retirement. Picture a portfolio geared toward capital preservation that’s only generating a 1% annual return. If inflation climbs to 4%, that portfolio has generated a negative real rate of return, which over time can erode a family’s purchasing power.

Steps you can take to help provide protection against inflation

While inflation can present challenges to investors, there are actions you can take to help mitigate its overall impact on your portfolio and your financial goals. Actions you can take include:

1. Practice Diversification. The best protection against inflation is to be proactive. Investors should think of inflation as an ever-present risk, similar to market drops and recessions, and diversify their portfolios accordingly. An investment mix that includes a combination of various asset classes may help generate the returns necessary to outpace inflation, while lowering your overall overexposure to market risk.

2. Carefully review your time horizon and tolerance for risk. Investors with longer time horizons and more growth-oriented asset allocations face less inflation risk than do investors with short time horizons and more conservative portfolios. If you find yourself in the latter group, you may want to reevaluate your tolerance for risk. You may find that the risk of inflation outweighs the additional risk you may incur by adding more growth exposure to your holdings.

3. Consider supplementing your portfolio with inflation-protected investments. In the short-term, it’s hard to predict with any certainty when inflation will strike. Rather than reinvent your asset allocation over this possibility, it might instead make sense to make small changes around the margins. Consider adding growth assets to your portfolio like stocks in businesses with fixed costs, or those able to easily pass on cost increases. Another consideration may be the inclusion of investments that have exposure to alternative investments such as real estate, for example. Given the research and vetting this may require, you may want to consider speaking with a Financial Advisor.

Contact a PNC Investments Financial Advisor, today

Inflation is an ever-present risk, and it’s important for investors to plan accordingly, especially when investing toward a long-term goal like retirement. Just like you might plan for the inevitability of market swings, it’s equally important to put plans in place to help mitigate the overall impacts of inflation.