Wikipedia defines inflation as “a rise in the general level of prices of goods and services in an economy over a period of time. When the general price levels rise, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money”.
We are all aware that prices generally rise over time. The question is: have prices been rising recently at a rate less than 2% - as the official CPI (Consumer Price Index) statistics suggest - or more than 6% as John Williams reports (see www.shadowstats.com )?
The answer depends on which formula you choose in your calculation.
The official formula has changed significantly over the last 20 years. A cynic would suggest that the adjustments have helped to reduce "stated inflation" to keep government payments low, since government pensions, social programs, CPP and OAS are all indexed to CPI. Using a lower inflation number saves billions in payments.
John Williams, however, calculates inflation using the formula as it was in the 1980’s.
- How does this impact investors and savers? If you thought that inflation was really averaging 6%, a bond or a GIC yielding 2% wouldn’t be very attractive at all. Your capital might be safe, but you would see a steady decline in the purchasing power of your savings.
- How does true inflation affect your investment portfolio? Traditional investment portfolios use a blend of stocks, bonds and cash. If we accept the official inflation statistics, then we must acknowledge that real yields on bonds and cash are largely wiped out by inflation. If inflation is actually higher than the reported numbers, then bonds and cash are an even worse investment. This means that only stocks, with all their inherent volatility, have a chance of protecting the purchasing power of your savings in the long run.
- So what can you do if you can’t stand the volatility of the stock market? You need to have something that helps reduce the volatility of your portfolio. Reducing the volatility will likely help you to stick to your long term investment plan. That is why we spend so much time searching for non-traditional investments to provide diversification for, and reduce the volatility of, a portfolio that has significant exposure to stock markets.
Understanding the impact of inflation is critical when building a long term investment solution. And it's worth keeping an open mind about the inflation numbers that are being reported these days.