Have you been to the grocery store, pharmacy, or your favorite shoe store lately? You may have noticed that the costs are higher than you remember. That’s inflation. When prices go up for basically the same product, it means your purchasing power is declining.

When it comes to your long-term financial independence, inflation is a key consideration. So today let’s talk about managing inflation risk.

Balancing Risks

As investors, we sometimes want to stop and protect our money once we’ve made it. We want to hunker down and invest “safely,” before any market storms blow in.

When it comes to an actual snowstorm, this can be a very good instinct. When it comes to protecting your purchasing power it is not.

That’s because investors must balance multiple risks. Inflation risk can sometimes be hard to see. It can be subtle and slow-moving. Investment risk is another risk we often talk about in this series. It is often louder and more aggressively reported by the media.

It is human nature to want to avoid risk, but it’s difficult to avoid both of these risks at the same time.

Inflation and Your Dollar’s Spending Power

So why do we care about inflation risk? Let’s illustrate what can happen if we ignore it, with a chart we often share with our clients at PWL Capital.

 

As this chart shows, if you have a retirement fund of, say, $1,000 today, and inflation hovers around its target rate of 2%, that same $1,000 will only be worth about $552 after 30 years. Remember, many Canadians will be in retirement for 30 years. If they ignore inflation, they could experience a significant reduction in their standard of living over time.

If you are interested, you can play with the numbers yourself with the Bank of Canada’s Inflation Calculator.

Inflation-Busting Investments

So what is the alternative? How do you protect your purchasing power? For many Canadians, this need is best met by allocating wealth to low-cost, globally diversified index or index-like stock funds. Investing in stocks in this fashion helps you maintain, if not increase your spending power over time.

That said, investing in the stock market entails risks of its own. How do you determine the right balance between safe-harbor holdings vs. sources of expected return? I’ve covered that conundrum in a past No Dumb Question that’s all about asset allocation – with a little golf thrown in. Why not swing on over to it, and check it out for yourself!