For many people, inflation can be a daunting word that may bring about images of sky-high prices and rising interest rates. And that means it becomes more expensive to spend on everyday products and buy long-term investments like a home. But the good news is that inflation doesn’t have to be intimidating when one understands it properly. Here’s what one needs to know about inflation and its impact on long-term finances.
What is inflation? Inflation occurs when prices rise. These rising prices mean the value of a dollar for the average consumer goes down. In other words, it costs more to buy the same products and services. Inflation is typically tracked by a percentage per year, with around 2% being average. So, at 2% inflation, the same groceries one bought for $100 last year may now cost $102.
A small bit of inflation over time is normal and to be expected. However, it’s when inflation happens quickly that the average consumer feels the impact the most. Inflation in the U.S. is measured by inflation indexes like the Consumer Price Index (CPI). The CPI looks at the price increase across goods and services from used cars to medical care and household furnishings. How does inflation affect long-term finances? There are several ways inflation can impact long-term finances, but luckily there are also ways to combat it:
1. Long-term investments must keep up with inflation. The average investor makes long-term investments over several decades (think retirement accounts like a 401(k)). And investors trust that over time, the money they put in will grow at a rate that outpaces inflation and regular economic growth.
Periods of high inflation tend to worry investors. That’s because they’re concerned that the money they put away today may not be worth as much in the future if inflation continues at a high level.
To hedge against this, investors will look to diversify their portfolios. Stocks tend to have a track record of “beating inflation,” meaning in the past they have grown at a rate that surpassed the inflation rate. So many investors look to include stocks in their portfolio as long as their time horizon allows it.
2. Inflation could make a term life insurance policy less valuable.
A term life insurance policy is designed to give financial protection to loved ones if you pass away during the term. But many terms last 20 or 30 years. And high inflation could mean the death benefit payout in today’s dollars may be worth less in the future.
To ensure loved ones are adequately protected, periods of high inflation could be the right time to consider increasing the coverage amount. A financial professional can help factor in inflation to calculate an appropriate amount of term life insurance to have.
3. Emergency savings may offer less protection. Having an emergency fund is a foundational element of financial success. And while it’s smart to keep this money easily accessible in cash, inflation can work against one by reducing the value of savings. It’s true that banks may be willing to pay more interest during periods of high inflation. But that may not be sufficient to combat the effect of inflation.
To protect oneself against inflation that could decrease the protection of an emergency fund, one may need to look at increasing the amount that one is holding. That means if one normally holds six months of living expenses in their emergency savings, bumping it up by one or two more months could offer the extra layer of security needed.
The bottom line
Some inflation is to be expected. But a period of continued inflation can cause concern and possibly some changes to long-term finances. It’s wise to work with a financial professional to assess one’s current financial situation and offer suggestions to protect one from the effects of inflation. Taking precautions now means more peace of mind later on. Investments carry some level of risk, including potential loss of money invested and past performance is not a guarantee of future performance.
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