Living with Inflation – How to Handle Inflation in Your Investment Portfolio

The last post described the long-term effects of inflation and explained how a COLA pension (plus a portfolio of equities) can stay ahead.

One of the issues with the COLA system is its reference: the Consumer Price Index, or CPI. Critics claim that the government manipulates the CPI to make each COLA as small as possible. Conspiracy or fact? Well, a little of both.

First, the CPI is made up of a number of smaller indexes, each with their own basket of goods and services. It can also be broken down into smaller portions like the “core CPI” for more detailed comparisons. The idea is to be able to compare effects consistently across the years while updating the index for changes in consumer choices and spending.

Next, although the CPI no longer includes the early 20th-century cost of whalebone corsets, it also may not include some of technology’s latest “necessities” like smart phones or late-model gaming systems. The Bureau of Labor and Standards periodically updates the goods and services that make up the CPI to ensure that they reflect broad consumer behavior.

Third, over the years the BLS has noted a number of consumer behaviors that affect the CPI. One of these is the “hedonic adjustment” caused by recessions or periods of high inflation. A family may usually enjoy a weekly steak dinner, but if the family wage-earner is unemployed or if the price of beef soars, then they may switch to a cheaper cut of meat– or even hot dogs. Another change in consumer behavior is known as the “Wal-Mart effect”. As Wal-Mart stores spread throughout the nation, their relentless focus on price-cutting is estimated to reduce inflation by as much as 15% of the annual rate. In other words, if inflation was rising at a historical 3%, the Wal-Mart effect can knock the price trends down to less than 2.6%.

These effects seesaw back and forth across the nation, from urban to rural regions, and from one year to the next. Their cumulative effects are subject to seasonal adjustments (like holiday shopping) and national phenomena like election years or the price of gasoline. As the BLS attempts to update the index or to accommodate the various effects, cynics and skeptics claim that the index is being mercilessly manipulated to reduce next year’s COLA– or even to raise it to pander to voter blocs.

How can an individual consumer adjust their portfolio savings and their spending to handle this fluctuation? It turns out that an individual’s spending doesn’t really have much to do with the CPI. If you’ve been tracking your spending for a few years then you may notice that certain restaurants have raised their prices or a pound of ground beef costs more at the grocery store. However, you may also have changed your own behavior: you’re eating at different restaurants or trying different types of beef. Your own spending varies from one year to the next just as the CPI varies across the nation and different demographics.

The best answer for a retirement portfolio is to keep an eye on inflation trends and choose an asset allocation that will keep up with (or even exceed) the rate of inflation. That’s usually an allocation high in equities, which have been the only asset class to consistently beat inflation over the span of a retirement. The best answer for consumer spending is to continue to put your money where it matches your values, and to be ready to “pay the price” for your values. You may decide that you’d rather have a higher savings rate and achieve financial independence more quickly, or you may choose to extend your career for a few months to enjoy a higher standard of living.

How did Groucho Marx handle inflation?

He was once asked what he invested his earnings in, and he responded “Treasuries!”
The journalist commented, “You can’t retire on just a portfolio of Treasuries.”
Groucho’s riposte: “You can if you have enough of them.”

Next post: How the military pension COLA is calculated, and why TIPS or I bonds aren’t such a good idea in a military retirement portfolio.

Related articles:
Effect of inflation on a dollar
Will Congress change military retirement?
Financial myths of retirement (part 1 of 2)
Financial myths of retirement (part 2 of 2)
The biggest benefits of a military retirement

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About Doug Nordman

Author of "The Military Guide to Financial Independence and Retirement" and co-author of "Raising Your Money-Savvy Family For Next Generation Financial Independence."
This entry was posted in Military Retirement, Money Management & Personal Finance. Bookmark the permalink.

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