7 things investors should know about inflation

When investors think about risk, they usually think about market crashes or other examples of investment losses. However, while this might be the investment equivalent of a head-on crash in a car, what can be equally devastating is the type of crash that blindsides you. Inflation is a prime example of a risk that can blindside investors.

After all, thanks to inflation you can make money on your investments and still find your purchasing power slipping away. In terms of long-term planning you might meet all your long-term savings goals because of inflation.And you still not be able to afford the standard of living you expected.

7 things investors must know about inflation

While there is no perfect way to defend against all forms of investment risk, the more you know about inflation, the better you can be prepared for it.

Here are seven things you should know about inflation:

1. Recent years have not been typical

The United States has been living in an extremely low-inflation environment for several years now, to the point where the relative lack of inflation has gone from being seen as a blessing to being a source of concern for some economists. Inflation data from the U.S. Bureau of Labor Statistics goes back just over 100 years, and over that full history the annual inflation rate has averaged 3.3 percent.

In contrast, over the past 10 calendar years inflation has averaged a full percentage point less, at 2.3 percent. Recent history even featured the lowest calendar-year inflation rate since the 1950s, at -0.4 percent in 2009. As a consumer, you may enjoy these low levels of price increases while they last, but don't get used to them because history suggests they are abnormal.

2. Unexpected inflation is the most damaging

The reason it is especially important not to get lulled into a false sense of security by abnormally low inflation is that inflation does its worst damage when people don't see it coming. If inflation were running at 5 percent a year, that would be considered a pretty high rate of inflation but bond yields and savings account rates could adjust, and retirement planners could take this into account. It is when inflation suddenly jumps from next to nothing to 5 percent that bonds would suffer losses, bank rates would likely fall behind inflation, and retirement targets would be caught short.

3. Factor inflation into your retirement assumptions

Speaking of retirement targets, the reason it is so important to accurately account for inflation when setting these targets is that they are so many years in the distance. This gives the compounding effect of inflation more time to take its toll. This means you plan for inflation not only in the years between now and when you expect to retire, but also in the 20 or so years you might spend in retirement.

4. Inflation has been more damaging to investors than bear markets

Think of history's great bear markets: the 1929 crash, 1987's Black Monday, and the 2008/2009 financial crisis. In each case, the stock market has recovered to go on to new heights. In contrast, because periods of deflation are relatively rare, inflation almost never gives back any of the value it has eroded from savings.

5. Inflation is especially harmful to bonds

This is where the notion of risk management gets tricky. High-quality bonds are generally thought of as very conservative investments, but they are particularly vulnerable to inflation. Rising inflation forces bond yields higher, and when that happens, bond prices fall.

6. Inflation hedges can be elusive

Given the threat posed by inflation, would you like to hedge against it? Easier said than done. Inflation-indexed bonds offer scant margins over the rate of inflation, so they can help you keep pace but don't build much real wealth. As for commodities, the trick is picking which commodities are going to drive inflation. If wage pressures are the primary force behind inflation, commodities won't really help you.

7. Inflation is a good reason to consider working longer

To some degree, wages adjust to inflation over time. This is a good argument in favor of working longer before you retire - keeping wage income coming in gives you some degree of protection against inflation.

Perhaps the most insidious thing about inflation is that it increases the element of unpredictability in retirement planning and investing. When inflation flares up, it tends to be very erratic, so you don't know quite what to expect. The best advice is to get as far ahead of inflation when it is quiet, because it can make up ground in a hurry once it is roused.

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