As prices reach once-in-a-generation highs, inflation has many Americans understandably worried about their pocketbooks.
What is inflation? Simply put, it’s the erosion of a currency’s purchasing power. When the inflation rate is 2%, for example, every dollar becomes 2% less valuable per year. Although 2% may not seem significant, someone earning $50,000 per year would see their effective income drop by $1,000 under such conditions — a substantial loss in wealth.
In the United States, inflation is surging well above 2% — the long-term level supposedly targeted by the Federal Reserve — with no signs of slowing down. Prices were rising at a 1.4% pace at the end of 2020, but they were rising at a 7% pace by the end of last year.
Indeed, Americans are already seeing the effect of inflation on their wallets — even before inflation reached the highest rate seen in four decades. Though nominal wages increased as the economy recovered from COVID-19 and the lockdown-induced recession, “real average hourly earnings” — which consider the effect of inflation — fell by 2.4% last year.
And according to economists, there is no immediate end in sight.
Larry Lindsey, the director of the National Economic Council under President George W. Bush, is warning that inflation could be above 2021 levels in 2022. “We’re going to continue to have inflation this year,” he said, “probably at or maybe even a little above what last year’s pace was.”
Looking at policy decisions from the Federal Reserve, Harvard University economist Kenneth Rogoff is equally pessimistic. “It’s not so easy to raise interest rates to fight inflation when public and private data is high,” he explained, “when the stock market is high, when housing prices are high, when the economy is still weak.”
What can average Americans do to stop inflation from eroding their wealth?
The key to battling inflation is realizing that the phenomenon only erodes the value of dollars. This is why rising price levels typically hit poor Americans — who are more likely to hold a high percentage of their portfolios in cash to pay their short-term expenses — harder than any other demographic.
The key to mitigating inflation risk is therefore holding as little cash as possible in the long-term — instead transferring your portfolio toward less liquid assets.
Real estate refers to land along with any permanent improvements attached to the land, whether natural or man-made.
Real estate serves as an inflation hedge for several reasons. For one, inflation benefits debtors because the value of the dollars they are paying to settle their obligations decreases over time. Due to inflation, someone paying back a fixed-rate mortgage taken out in 2020, for example, is paying with less valuable dollars in 2022.
As with the stock market, the general trend in American real estate is a steady increase in equity over time. However, there are important exceptions — such as the economic decline of individual regions and national phenomena such as the 2008 housing crisis.
Those who cannot afford to purchase entire properties are able to invest in real estate at a smaller scale through real estate investment trusts (REITs) — companies that own, operate, or finance income-generating properties. Shares of REITs are publicly traded and pay dividends based on the profits of properties in the portfolio.
As most people know, a stock is an asset that represents the ownership of a fraction of a company — entitling the holder to a portion of the company’s assets and profits. For example, buying one share of Apple — currently priced at just over $175 — would grant the holder a sliver of the world’s largest company, as well as a $0.22 quarterly dividend payment.
Beyond individual stocks, investors can purchase exchange-traded funds (ETFs) — which entitle the owner to a share of a pooled collection of securities. Many of the most popular ETFs — such as SPDR and Vanguard’s S&P 500 ETFs — track the performance of the overall stock market, meaning their value goes up and down alongside the United States economy.
One may think that small-time investors cannot earn significant returns when passively holding index funds. However, active management — by which finance professionals manually configure a portfolio — often yields lower returns than passive management. As of 2019, 85% of large funds underperformed the S&P 500 over the course of a decade, while nearly 92% trailed the index after 15 years.
As Berkshire Hathaway chief executive Warren Buffett affirms, the average investor should “just buy an S&P index fund and sit for the next 50 years.” Indeed, the S&P 500 boasts an average annualized return of 10.49% between 1926 and 2021 — growing its value along with the growth of the American economy.
Treasury Inflation-Protected Securities (TIPS)