If seeing your investment account decline week over week during a period where the price of goods are also increasing and eating into your monthly budget isn’t a test of one’s patience, then you are an emotionless rock.
All kidding aside, it is important to be level headed during times of volatility, but it is also important to be level headed and responsible during times of inflation and rising interest rates as eluded to in Lesson 81. As discussed in Lesson 60, inflation occurs when the average price of a good or basket of goods increases over time. And while an optimum level of inflation is ideal, over inflation needs to be avoided for any good or service as this will drive up prices dramatically, making it unaffordable to most consumers.
Central banks will react by raising rates on overnight lending bank rates, which will affect the rates that bank set for short- and long-term borrowing, in order to cool down the economy and consumer spending. As discussed in Lesson 76, when inflation is present, asset prices increase, and therefore, with all else constant, purchasing power reduces for consumers. Lower spending means lowered demand for goods which means prices will be adjusted downwards to maintain supply demand equilibrium. In theory it is straight forward, but in reality, this correlation takes time to adjust. As much as expansion and growth is a part of the economic cycle, so are downturns and recessions. It’s a continuous sinusoidal wave that regresses back to equilibrium when supply exceeds demand, and when demand outpaces supply. The frequency of this wave may elongate or shrink depending on the economic conditions of a country such as currency strength, interest rate and interest rate policy, employment and jobs data, CPI movement, trade deficit, and fiscal/monetary policy.
Central banks will usually aim for a “terminal” interest rate where they will slow down interest rate hikes to up until that terminal interest rate is hit. A slowing down of interest rate hikes is seen as “dovish”, and is indicative of slowing inflation and a topping of interest rates, at least in the short term. The opposite can be said for a ramping up of, or even sustained, interest rate hikes, which is seen as more hawkish by central banks in that inflation is not yet under control and that a terminal interest rate is still not achievable in the short term.
So how does one person go about combatting inflation? The simple answer: be a part of it. Inflation will drive up the value of assets, including the ones that you own, and you won’t lose purchasing power if what you own goes up in value in lock step with inflation.
Now the long answer is more nuanced, and below are a list of suggestions to better prepare against rising asset prices and interest rates. Dealing with inflation and rising prices of goods will be challenging depending on your current household income and financial independence, as well as age and proximity to retirement. Because of these challenges, I realise these suggestions should be taken with a grain of salt.
Own assets
Remain diversified across stock market (i.e. own market ETFs, or stocks across different sectors)
Own assets across both US and Canada (across indices) to hedge against dollar strength/weakness
Unless needed in the near future, limit cash balances in investment accounts. Cash devalues at the rate of inflation annually
Adjust weighting of portfolio to incorporate fixed income (i.e. treasuries, bonds) to take advantage of high interest rates
This weighting may differ depending on how old you are, how close to retirement you are, and when you plan on needing this invested money in the future
Ladder and spread out fixed income durations – own some short term and some long term. When short term bonds become due, they can be reinvested in whatever the current rate is, or used for whatever you had planned the money for
Be mindful of interest rates on short term and long term debt. These rates will change (likely go up) during an inflationary time period, and may motivate an individual to lock in debt at a lower interest for a longer duration. Alternatively, if rates have already risen substantially, individuals may look to shorter term duration interest rates on debt obligations. Variable interest rates on a 1 - 5 year term mortgage may be more appealing following a series of interest rate hikes where central banks have indicated a more dovish policy (i.e. slowing down of interest rate hikes), whereas fixed rate 1-5 year mortgage terms will be more appealing during a ramping up of or sustained interest rate hikes.
Revisit your family/household weekly/monthly/annual budget, and take a second look as to your household spending on non essential and consumer discretionary goods (entertainment, eating out, shopping, vacations). This may need to be adjusted as cost of living goes up (consumer staples, utilities, fuel, rent, mortgage, etc.)
Revisit with financial advisor to see if your retirement plan needs adjusting in the face of short-medium term inflation and higher interest rates
Being an emotionless rock is good to avoid irrational and emotional investment decision making. However, it shouldn’t excuse oneself from being mindful of and reviewing their financial situation during an inflationary environment. Figuring out whether there are any proactive or reactive steps to position oneself better in response to inflation is a necessary and responsible tactic to ensure financial stability and well being for oneself and their family.