A few basic strategies can help you beat the curve.
Inflation is a general rise in the price of goods and services in the economy. It results in a loss of purchasing power if income fails to keep up with inflation since each dollar of income will buy less of a good or service than it did previously. Inflation is usually measured by the Consumer Price Index (CPI), which reflects the weighted average price of a basket of goods and services consumed by the average household. From 1926-2005 inflation has increased at an average rate of about 3% annually. However, there have been periods such as the 1970s and early 1980s when inflation increased by over 10% annually.
It should be noted that these numbers deal with averages; a more appropriate measure of inflation for an individual is the personal rate of inflation. Inflation affects individuals differently depending on individual income, geographic location, consumption of specific goods and services, and allocation to various investments. For example, a married physician living in New York City with two college aged children may be more sensitive to inflation due to higher housing costs, heating costs, and education costs than a single physician living in the rural Midwest with no children. The only way to determine your personal rate of inflation is to accurately measure your yearly personal expenditures and compare that with your yearly income. For example my 2007 personal expenses were less than my 2006 expenses even though my income was stagnant.
6 STRATEGIES FOR FIGHTING INFLATION
>> Work more, faster
Simply put, if your personal rate of inflation exceeds your rise in income, you can always work faster, or work more shifts. For incentive-based physicians, seeing more patients per hour not only increases gross income but it also increases pay-per-hour. However, at some point you reach a limit to the number of patients you see per hour, and you increase the risk of making mistakes leading to possible malpractice lawsuits. Similarly, there comes a point where the number of shifts you work compromises your lifestyle.
>> Budget living
A second way to address the inflation gap is to reduce your personal expenses by adhering to a budget. After all, do you really need heated car seats when you live in Florida? Do you need to finish the basement on your 5000 square foot house when you have no children and face $100,000 in student loans? Of course some expenses are fixed, such as mortgage payments, insurance premiums, and child care expenses for which expense reduction is nearly impossible.
The third option is to generate inflation-beating returns (known as real returns) from your investments. The goal is to preserve an investment portfolio’s purchasing power so that future liabilities, which increase at the rate of inflation, can be adequately met by an equal or greater increase in assets. Due to the compounding effects of inflation, there is a greater erosion of purchasing power as the time horizon lengthens. Assuming a 3% inflation rate, your purchasing power declines by over half in 25 years, which is well within an individual’s investment timeframe. With just a slight increase to 4%, it declines by nearly two-thirds. In other words, it would take twice as many dollars in 25 years to purchase the same goods and services as it would today assuming average inflation, and almost three times as many dollars assuming inflation rate is 4%
>> Investments, Part II: Stocks
Stocks have historically provided long term returns in excess of inflation of about 6%, albeit with high variability. To beat inflation with stocks, make sure you invest in them for a minimum of ten years since in the short term, stocks have had negative real returns with unanticipated high inflation the majority of the time. For most of the 1970s and again most recently from 2000-2002, the real rate of return on US stocks as measured by the Dow Jones Industrial Average was negative, indicating a loss of purchasing power. Similarly in the long run real estate stocks also beat inflation, as shown by the fact that the CPI more than doubled from 1980-2006 while real estate stocks increased over five fold.
>> Investments, Part III: Bonds
Bonds fare worse than stocks with inflation but have still achieved a long term real return of about 2%. The interest payments from a bond include the risk assumed for anticipated inflation. With unanticipated high inflation, prices of bonds decline even more than stocks. In fact for a period of four decades from 1940s to 1970s the real return on US Treasury bonds was negative. To mitigate the effects of inflation, make sure you buy short term bonds with maturities less than 5 years.
Recently two types of government issued bonds guarantee inflation protection, I bonds and Treasury Inflation Protected Securities (TIPS). The I bond is a savings bond which pays a fixed interest rate and on top of that adds an inflation rate based upon the CPI so that it nearly guarantees a return that beats inflation. TIPS are government bonds whose face value periodically increases at the inflation rate. Interest payments also increase based upon the inflation adjusted face value to guarantee a positive real return.
>> Investments, Part IV: Gold
Gold historically has been seen as a safe haven in times of inflation. As a commodity it is expected to have a return of zero after inflation. One study determined that from 1895 to 1999, the price of gold matched inflation but did not beat it. Over the past two decades though gold has lost its glitter. In 1980 gold was selling for over $800 per ounce, which is the same price as it is today, more than 25 years later. To match inflation over that time frame, gold should be selling for over $2000 per ounce today! By comparison an investment in US stocks from 1980 to today would have grown over ten fold.
While there is no perfect inflation hedge, the key is mixing a variety of investments together in order to produce long term positive real returns since each responds to inflation differently. Physician pay has not kept up with inflation, resulting in a decline in our purchasing power. Strategies to offset personal inflation include increasing gross income by increasing workload, reducing expenses, or investing in inflation-beating investments. Each strategy has its own unique advantages and disadvantages.