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Inflation. It’s a word that gets thrown around a lot in the financial news, and when it does those financial talking heads just kind of smile and nod knowingly as if they know what the Hell it means and why it’s important.
Here’s the truth.
Almost nobody fully understands Inflation.
Why?
Inflation is fucking complicated.
In fact, try reading through the Wikipedia article on Inflation and see how far you make it before your eyes glaze over and you start thinking about checking your Facebook status. Truth be told, I was confused by Inflation for the longest time, and spent a great deal of time reading books about economic theory to try to make sense of it all.
And those books were boring. Oh, God, SO boring.
The media doesn’t really help here, breathlessly reporting every move by the Federal Reserve without bothering to explain how it actually effects people (again, because they likely don’t understand themselves).
“The Federal Reserve hiked interest rates a quarter point to combat rising inflation!”
Me: Oh, OK. If you have to “combat” something, it must be bad. High inflation is bad. Got it.
“A slowing economy is making inflation plummet, so the Federal Reserve is lowering interest rates to stimulate the economy!”
Me: Wait. Low Inflation is also bad? How can that makes sense?
“Venezuela’s inflation has hit a record 800% as the country spirals into collapse!”
Me: OK, well I know something “collapsing” is never good, and 800% sounds really high, so a REALLY high inflation rate must be REALLY bad.
“Japan remains mired in a deflationary spiral and Prime Minister Shinzo Abe has unveiled a series of economic policies to fix it.”
Me: Wait, so negative inflation is ALSO bad? What?!?
But at the same time, we can’t just ignore inflation, since it factors into how we invest. Not a day goes by that some snide reader doesn’t email us going “Oh yeah? Well let’s see how well your retirement portfolio lasts after it gets EATEN UP BY INFLATION.”
So how do we wrap our head around this thing?
Well, what really helped me was realizing that there are really two types of inflation you need to understand: Macroeconomic inflation and Personal Inflation.
Macroeconomic Inflation
This is the Inflation that newspapers and the financial media blather about. Here’s Wikipedia’s eye-wateringly boring technical definition.
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time resulting in a loss of value of currency.
Well that clears things up.
So let’s break that shit down into something a bit more understandable.
A country’s economy, at its core, is a bunch of people doing stuff for each other. I wake up and go grab a bagel, and a baker helpfully bakes it for me. Then I catch a subway who has a driver operating it for me. Then I go to work (or at least, I USED to go to work) and write software that, hopefully, helps someone else do something useful. And greasing the wheels of this system is money. At every step, money is exchanged. And this giant swirl of people exchanging money and helping each other do things is called “The Economy.”
Got it? Great.
Well, the value of that money (i.e. how many bagels $1 buys) changes over time. This change is basically Inflation.
Now what makes inflation so complicated is that it’s affected by about a zillion different factors, often in ways that are not obvious at all. Interest rates affect it. Elections affect it. Wars affect it. Even something that happens in another country can have weird knock-on effects on your country’s inflation.
Let me give you an example.
In late 2015/early 2016, oil was the big news story in the finance media. What basically happened is that OPEC, led by Saudi Arabia, was starting to get worried that the US was starting to produce more oil domestically using a technique called fracking instead of buying it from them. So they flooded the market with oil. The insane increase in supply drove the price of oil down on the commodities market, from over $100 a barrel to somewhere around $30. The idea was to make oil so cheap that the US frackers would go out of business.
Sideswiped in this mess was Canada, where a major part of our economy is extracting oil out of the oil sands in Alberta. Currency traders correctly predicted this would fuck us over, and dumped the Canadian dollar. Our dollar went from about parity with the US greenback all the way down to $0.67.
Here’s the problem, we buy tons of shit from the US ALL THE TIME. Because Canada freezes for a third of the year, we can’t grow enough food to feed our population. So we buy food and produce from American producers. But since our currency dropped so much, all of a sudden that food started getting more expensive to buy. Which translated to higher prices at the grocery store. Which caused our inflation to pop upwards like crazy.
That’s why inflation is such a complex subject. A Saudi oil baron getting into a fight with US frackers can somehow cause a Canadian’s grocery bill to skyrocket.
So back to our original question. Is high inflation good? Or is it bad?
And like that annoying friend on Facebook who keeps kinda-breaking up with her boyfriend but then kinda-keeps seeing him, the answer is “it’s complicated.”
Negative inflation (or deflation) is bad. This is because deflation means the value of money is INCREASING over time. And while that sounds like a good thing, what it actually does is cause people not to buy things. If you knew your money could buy more goods tomorrow, you’d hold off spending it. Deflation causes an economy to grind to a halt because people hoard money.
But really high inflation is also bad. Think Venezuela, or pre-WWII Germany. Inflation of 800% or 1000% basically means that tomorrow, your money becomes worth way less. So people can’t WAIT to buy something to get rid of it. But if they’re buying stuff not because they need it, but because they have no faith in that currency, that’s not good either. Would you like to be paid in Venezuelan Bolevars right now?
So in order for an economy to be stable, inflation needs to be positive (so people spend the money rather than hoard it), not too high (so people aren’t setting it on fire for warmth), and steady. Economists have generally agreed that inflation of around 1-3% is the sweet spot.
Why Do I Care Again?
You want to invest your money in an economy where inflation is hovering around 1-3%.
Major developed countries have a central bank, whose primary job is to maintain an inflation target of 1-3%. They have many tools to do this, like adjusting interest rates, issuing debt, purchasing assets, or printing money. In the US, this is the Federal Reserve. In the UK, this is the Bank of England. In Canada, this is the Bank of Canada.
In fact, when we saw that inflation spike caused by the Saudis and their oil surge, the Bank of Canada dropped interest rates in an attempt to stimulate the economy and it worked. Our oil industry still got decimated, but other parts of our economy benefited, our dollar came back up in value and inflation stayed within the 1-3% inflation target.
So while we advocate index investing, we need to clarify to invest in indexes of countries whose central banks know how to control inflation. Because if they allow inflation to go out of control, their entire economy suffers and their index gets screwed. Examples of central banks who have demonstrated the ability to do this are Canada, the Eurozone, and of course, the US. Which is why our Workshop ETFs are all domiciled in these countries. Do NOT buy a Venezuelan Index ETF.
And secondly, inflation affects your portfolio allocation in retirement. Traditional retirement strategy dictates that after you retire, you move more and more of your portfolio into fixed income. But for reasons discussed in the last Workshop Article, this doesn’t work for early retirees. Our retirements are 60 years, not 10. And in that timeframe, inflation is a huge problem, because fixed income doesn’t scale with inflation. A bond paying $50k annually will still be paying that amount in 20 years even if food now costs 50% more (that’s 2% compounded over 20 years). But you know what DOES scale with inflation?
Stocks.
This is because stocks represent businesses, and businesses selling stuff to people will always adjust their price to match inflation. If a bag of chips cost $1, and inflation is running at 2%, next year that business will charge $1.02. That’s literally the definition of inflation. Stuff costs more now.
And that’s why even in retirement, we don’t advocate bringing your equity allocation below 50%. Because you need that equity to hedge against inflation. Personally, we’re sitting at 60% equity/40% fixed income ourselves, and that decision has proven to be the correct one. 2 years into retirement, our net worth is actually MORE than when we left.
So that’s Macroeconomic Inflation. Tune in next week where we will talk about Personal Inflation, and how you can control it and make it your bitch.
Peace out.
Continue onto the next article!
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One area people might get caught out with inflation is when planning their retirement date. I, for example, could retire in 15 years or so (assuming a consistent savings rate) with $1,000,000 in the bank and $40,000 in annual expenses (4% withdrawal rate). However, if inflation forces my annual expenses up by 30%, I’ll now be spending $52,000 a year and will require $1,300,000 to maintain my current life. This could feasibly add on several years to my retirement date.
Inflation is one reason I am somewhat tempted to buy a house one day. At least you know you will never have to worry about rent increasing when you own a property. Real estate is an excellent hedge against inflation, just as stocks are.
Yes I agree about the house thing if you plan on staying in once place after retirement. While I value the advice offered in this blog I don’t agree with the not buying real estate thing but it depends of what retirement looks like for you. Retirement to me looks like staying at home and working on art, I hate the idea of having to travel around and not having a home base but if it works for them then that is great. Judging by your screen name, you’d probably not want to buy locally if you plan on retiring early though. I recently just sold my townhouse in Metro Vancouver with no plans on ever returning to live in the area because it will be too expensive to live there and FIRE at the same time. I have family in northern BC so if I bought again it would probably be there.
I agree, I don’t think too many are cut out for not having anywhere permanent to live. I actually find their $40,000 per year world travels a bit unrealistic long-term as eventually people want a permanent place to call home, in which case you’d either have to rent or buy a place in Canada whilst doing all this traveling. I’m curious to know where they stay when they do come back to Canada, and where they keep all their stuff. Certainly it would be great to travel the world for a year or two or five but soon enough most people want to settle.
And no, I don’t expect we will ever be able to buy in Vancouver, though we will do if it becomes financially worthwhile. Rent here (whilst high) isn’t unmanageable at the moment though and we can certainly reach FIRE whilst renting in Vancouver. If that’s the case and we want to buy, we’d move to another city with a lower cost of housing. Luckily for us all of the UK is an option too, so I don’t have to freeze my butt off all winter like most of the affordable Canadian cities have to. Not that the UK is incredibly cheap, but there is a lot more choice of where to live than Canada if you dislike being buried in snow all winter. Unfortunately here you are very restricted to a few cities and most of those cities are very expensive as a result of being the only climate in Canada that has a reasonably warm winter.
“a permanent place to call home? ”
Who are you? a baby boomer? World is my home!
i wont buy here in BC > . even if prices drop like 40% . .. one major reason … earthquake zone …. i read how a minor earthquake effected New Zealand . .and i don’t believe that insurance companies could pay if there is billions of damage and how long would it take anyway to repair the roads , schools , houses etc . years and years ??
and what would real estate prices look like then ?
i am retired and i would move back to the UK and rent there , not buy . i love the freedom of renting now after years of home ownership .
i am happy here on Van island renting and with freedom to travel ..
I’m sitting in a beach-front condo in South America right now that rents for $500 a month. Just sayin’.
Nice! That’s what I’m talking about ! Where are you Wanderer? Brazil? Colombia?
Looking forward to Friday’s South America travel post !
We’re still finishing up the Asia travel posts before moving on to Central/South America, but we should be able to get to them soon.
Thank you for reading the boring economics books on inflation so I don’t have to!
Oh my God they were SO BORING.
Awesome and relevant post! I was just wondering the Fed was doing in the headlines :).
You nailed it. Great explanation. I’m the US, the 70s were rampant with inflation. The problem when inflation gets out of control is it’s hard to stop. Like you said, if you know that TV you want us going to cost 50% more in a matter of months, you’re going to speed up your timeframe and buy it now. That in effect increases demand which cause suppliers to raise prices and inflation goes up even more.
As you said, it’s a tricky subject. Too much inflation or too little is a bad thing. And it’s a challenge to manage it in that sweet spot.
Thanks! You have NO idea how long it took me to understand this topic. I have a new respect for central banks now. Before, I thought all they did was print money whenever the government needed more of it.
True. However countries with high inflation usually increase their interest rates to high levels (see Brazil) to control that.
What if you live in the US and invest in fixed income in Brazil. As you don’t live there you wouldn’t suffer the inflation effect eroding your money (of course there is the FX to worry about)…..would it be a good strategy? I know people who does that !
I would also like to know the answer . . . . or opinion to investing in fixed income in Brazil
If you live in Brazil this play doesn’t make sense precisely because of that high inflation. And if you live outside Brazil this is a FX play. Unless you REALLY know what you’re doing, I wouldn’t touch this with a ten foot pole.
FX is different than index investing. In index investing, you are simply latching onto the overall economy. Every investor can win. FX is adversarial. One side wins only when the other side loses money. So when you do FX trading, you are playing against people who do this for a living, or computer algorithms that can process information in a split second.
In the FX space, you’re in a shark-eat-shark world. In Index Investing, a rising tide can lift all boats.
I have money invested in Brazil. I am a preferential customer of a Brazilian bank and my money makes 1% per month! Yup, 12% a year. Worth taking a look.
Hi Wanderer,
Great article.
You make this statement:
Because you need that equity to hedge against inflation. Personally, we’re sitting at 60% equity/40% fixed income ourselves, and that decision has proven to be the correct one. 2 years into retirement, our net worth is actually MORE than when we left.
That’s not quite right. Just because something has gone up, doesn’t mean you did a good job. You have to compare it to what it would have been if you’d invested in a different mix of assets and then say:
Did we do better or worse than a different asset allocation?
Why did that happen?
What can we learn from it?
I know you’re in fixed income to protect on the downside, but I’ve found the most useful thing for learning about what you are doing are these kinds of comparisons.
I developed a strategy for trading shares, it’s done ok (10% return), so I’m just about to pat myself on the back for a job well done, but then I looked at the stock market and it has gone up 20% – bugger, there goes my idea up in smoke. But it’s just a small part of my porfolio that I’m experimenting with (maybe stupidly), so that’s ok. Anyway, I’m definitely not feeling so smart about that idea now……:)
The other thing that’s important to point out here is that you’d want your portfolio to be increasing by the level of inflation anyway – otherwise every year that portfolio is ACTUALLY decreasing in value, because it can ultimately in the real world buy less and less, because of inflation.
This is why it’s very, VERY important when house prices rise faster than inflation, because they are becoming more and more difficult to buy even if you have something (like shares or other things) that are keeping pace with inflation.
If you continuously compare your performance to every other possible investment out there, you’ll go nuts.
Know what risk/volatility/yield needs you have, and invest to meet those needs. That’s it.
It wasn’t actually suggesting you compare to everything else out there, just what’s comparable, if that’s all you can be bothered to do.
This is exactly the kind of nonsense that fund managers get away with, they say their strategy was correct because they made 5%, when in fact they are doing worse than a tracker fund.
You’re advising people on finance in a PUBLIC blog, you need to be able to answer the questions that people ask and substantiate what you say; so when you say the decision was correct; it’s justifiable that people would ask – how do you know it’s correct? Where’s the evidence?
Inflation is actually the complicated topic to be understood by anyone. But , that is the only one thing to attract many investors to invest. But, inflation taking place is really unpredictable as it is based on many factors.
I just wan’t to know the factors effecting inflation, could you please list out Wanderer ?
I could rattle off a few off the top of my head, but it wouldn’t be a complete or thoroughly researched list. Pick up an economics book (but don’t do it when you’re trying to operate heavy machinery. Just trust me on this.)
going back to Yield and dividends
why not ditch bonds altogether ?
60% equities
20% Preferreds
20% Reits
this portfolio has long term growth and superb dividends inching/reaching towards that magic 4 % monthly yield .
(in the above i have ditched bonds and increased the Reits weighting )
ok it doesn’t have bonds to do the rebalancing etc
but bonds are historically priced high now and not the best in a rising rate world anyway
and when one is at the Yield shield , who cares about rebalancing etc
one can sleep at night in a crisis in the markets because you know that all the bills will be paid from the monthly dividends and one knows that you will get long term growth .
its the best of both worlds ; income and growth
any thoughts ??
That’s the plan!
I haven’t completely exited the bonds and converted them to Preferred Shares/REITs but I’m probably going to do that over time. I try to change my allocations gradually rather than whipsaw them violently at once.
exactly the same as me .
i will slowly exit bonds as the buying opportunities come along .
So for someone just starting out, is it better to look into preferreds and reits? Or should I stick with the 40% in bonds?
Also, how risky is it to drop my entire sum from my old rrsp to my new questrade account? Or should I DCA it over the next 12 mos?
If you’re just starting out I’d stick with a regular bond index for your fixed income allocation. Preferreds and REITs are better for yield and will become more useful as you get closer to retirement.
As for what’s a good fixed income allocation, that depends on your investment timeframe and risk tolerance. Check out https://www.millennial-revolution.com/invest/workshop-invest/workshop-deciding-equity-allocation/
As for DCAing, I generally suggest newer investors DCA. It’s just less scary than lump-sum investing.
Thanks for the reply:)