Are You Prepared for Inflation?

A good friend asked me the other day, “what financial risk do you think most people are unprepared for?”  With the progress in the last couple of years of helping people to save, take baby steps, establish and emergency fund, and give up lattes, most people that I know are in much better shape with regard to preparations for an unplanned emergency or just chronic over-spending.  However, I also think most people, including some friends and family, are woefully unprepared if we enter into a bout of inflation.  I know that I may be leaning more toward an inflationary view than some people, but my view is that moving into a period of rising prices is something we need to be prepared for, especially as a risk scenario.  Here are some things that I asked my friend:

--Are your long-term investments primarily in bonds?– bonds have generally performed well over the past decade, relative to stocks, in part because we have been in a long period of a secular decline in inflation.  However, as the recent month has shown us, with yields on US Treasuries at or near historic lows, the risk is that they can rise rapidly.   Given that inflation erodes the value of bonds more than most other investments, diversification would be prudent. In particular, I am invested in equities, both domestic, and international, overweight in emerging markets, and have some commodity related investments which should outperform if inflation in the US kicks up.

–Are you saving single digit percentages of  your income, or less, each year? — if you are saving less than 10 percent of your income each year for retirement, this tells me that you feel your expenses in retirement will be similar (or less) than what they are today.  If you use some of the financial calculators and retirement planners online, you’ll see that a 3-4% rate of annual inflation can mean much higher expenses in the future.  If you feel you cannot contribute more to retirement because you are paying down debt, try to add to the retirement pile as your debt reduces, rather than increasing your current expenses.

–Do you plan a budget that is pretty much the same as last year? — although many items can be relatively little changed year to year, take a look at the prices of things from the 1970′s or 1980′s.  Health insurance and college tuition are two items that have had dramatic increases each year for the past few decades.  Food inflation is something that many people are watching, as well.

If you answered yes to any of the above questions, you may want to rethink your preparedness. Being better prepared for inflation is a good way to make sure your financial health is protected for the long-run.

An editor’s pick a this week’s Carnival of Personal Finance