Understanding Inflation: How It Affects Your Wallet and Your Portfolio

“If annual inflation is around 3%, why do my bills seem like they’re so much higher than last year?”¹

In today’s economic climate, many of us may find ourselves asking that question, but it illustrates the importance of understanding how inflation is reported and how it can affect both your wallet and your investment portfolio.

What is Inflation?

Inflation is defined as the rise in the average level of prices. To monitor these trends, the Bureau of Labor Statistics releases a monthly report called the Consumer Price Index (CPI). The CPI evaluates expenditure information provided by households and individuals on their purchases in key categories such as food, housing, clothing, transportation, healthcare, recreation, education, communication, and other services.²

How Relevant is the CPI?

While it is one of the most commonly used indicators of inflation, the CPI has come under scrutiny in recent years. For example, the CPI rose 3.2% for the 12-month period ending in July 2023, but a closer look at the report shows price movements on a more detailed level, including a 12.5% decrease in energy prices over the same period.²

Can Inflation Impact Your Investments?

Absolutely. As inflation rises and falls, there are three notable effects to investment strategies to be aware of:

1. Inflation reduces the real return on investments. If the return on an investment is 6% over a 12-month span and inflation averages 1.5% during the same period, the real rate of return adjusts to 4.5%. When factoring in taxes, the real rate of return may be reduced even further.³
2. Inflation puts the purchasing power of money at risk. When prices rise, a fixed amount of money is able to purchase fewer and fewer goods.
3. Inflation can influence the Federal Reserve’s actions. Rising inflationary pressures could lead the Fed to curtail the money supply in an effort to combat inflation. Theoretically, a lesser money supply would translate into reduced spending and potentially lead to price drops and lower inflation.

Empower Yourself with Professional Guidance

During periods of low inflation, it’s easy to overlook how prices really affect your household budget. However, when inflation is high, many feel the need to make drastic changes in response to these increased prices. The most pragmatic course of action is to consult with a financial advisor who can help you develop or adjust your investment strategy to accounts for these different scenarios.

¹USInflationCalculator.com, 2024. Data reported as of July 2024.

²BLS.gov, 2024.

³This is a hypothetical example used for illustrative purposes only. It is not representative of any specific investment or combination of investments. Past performance does not guarantee future results.