Investing against inflation

Inflation is at its highest point in decades, and interest rates are on the rise. For many investors this type of environment is unknown after years of low rates and stable prices, creating multiple questions for physicians tending to their investment portfolios.

Doctors close to retirement may wonder what impact this economic volatility will have on their investments and how it will affect their timeline for hanging up their stethoscopes. Younger physicians are grappling with student loan payments and rising prices for almost everything and may be wondering where to put their money.

These are all valid concerns. “Not only does inflation erode purchasing power, it can have a detrimental impact on an investment portfolio,” says Michael Joyce, C.F.A., C.F.P., president of Agili, a financial planning and investment management firm. “If inflation increases, interest rates will also increase; bond prices will fall when interest rates rise. But there will also be a negative impact on stock and real estate values. As interest rates rise due to inflation, the stock market will be discounting future earnings with a higher discount rate, which means lower values.”

Investors have to be cautious to consider all factors affecting their portfolio. “Sure, an investor might see a return of 7% on their portfolio in a given year. However, what if inflation for the same year was measured by the Consumer Price Index at 9%?” says Jeff Pratt, CRC, a financial advisor with Finity Group, which specializes in financial planning for medical professionals.“On paper that’s a real return loss of 2% since the portfolio growth didn’t keep pace with inflation for the same year.”

If inflation rises to the point where consumers shift from being unhappy about paying more to not buying products, this could have even bigger economic consequences. “Inflation can only outpace wage growth for so long before consumer spending is negatively impacted, and drop-off in consumer spending could in turn lead to an economic slowdown,” says Pratt.

Clear goals help protect your investments

Physicians who are close to retirement have reason to be more worried about their investments as inflation rises because they have a shorter timeline to weather an economic storm and recover any losses. They might be tempted to make sudden changes to their portfolio, but experts say this isn’t always the best strategy.

“Regardless of whether it’s inflation or any other factor, investors should remain focused on their long-term goals and be cognizant of not taking on risk — or too much risk at the very least — they can’t handle,” says Pratt.

If, for example, a physician is nearing retirement with a $5 million portfolio and anticipates only needing $100,000 annually to meet their lifestyle needs due to other income sources, this person may not need any adjustment, says Pratt. But if the lifestyle needs require $500,000 a year, that is a faster draw down and will have a much larger impact on the portfolio, possibly requiring some assets to be repositioned. On the other hand, if they have a short life expectancy with no goal of leaving wealth to heirs or charities, this may not matter.

Investment strategies need to match overall goals and not just be knee-jerk reactions to changes in the economy.

“Diversification is the key,” says Joyce. “Physicians should include investments in their portfolios that will perform relatively well in a rising inflation environment.”

And if a lot of time was spent planning investments early on, there is one key move to keep in mind. “Assuming they were invested appropriately for retirement, the best move is likely no move at all,” says W. Ben Utley, CFP, president and a primary advisor at Physician Family Financial Advisors, a firm exclusively serving physicians.

If moves are required, Joyce says investors should look at options such as inflation-protected bonds, commodities, short-term bonds (which are less interest rate sensitive), stocks that pay high dividends and real estate that generates a lot of cash flow.

One option is Government Series I Savings Bonds. These can be purchased at Treasurydirect.com, but there’s a limit of $15,000 per calendar year. However, they are exempt from state income tax.

“Once an I bond is purchased, the money must be left in the bond for at least a year,” says Pratt. “Also, if cashed out in less than five years, then the previous three months of accrued interest is forfeited. Because of this, Series I bonds are most likely to be considered by folks with cash needs between one and five years out.”

Each inflationary environment is driven by different factors, so there is no one-stop shop to inflation-proof a portfolio, notes Pratt. Lower-duration bonds, which have less exposure to inflation and rising interest rates, might be one option. But within equities, high-quality companies with competitive advantages that give them pricing power in their industries are worth considering.

“The idea here is that these companies will be able to pass along price increases to consumers without significantly affecting demand — or their profit margins,” explains Pratt. “Fixed income typically struggles in an inflationary environment, but as an asset class it can still be an essential risk management tool despite potential headwinds.”

Will rising interest rates derail retirement plans?

The COVID-19 pandemic and the economic and mental hardships it caused forced some physicians to consider retiring sooner rather than later. But that was before inflation started eating away at investment earnings and concerns about the future of the economy came fully to bear. If a physician had been looking to retire in the next three years, is that still a good idea with so many unknowns?

“Three years from now, everything will look very different,” says Utley. “I mean, look at where we were three years ago. Nobody could have seen today’s dumpster fire glowing in the distance. I think older physicians should have a very solid plan before they make the decision to hang it up. Going back to work, especially after a failed retirement, is no fun.”

Physicians looking to retire soon should determine whether they are financially independent enough to go from earning their money from their hard work to depending entirely on their financial investments. This should include an analysis that includes a stress test of a major market downturn the day of their retirement, says Joyce.

“The knee-jerk reaction to ‘just do something’ about inflation is probably going to be the wrong move at the wrong time since the market prices of securities already reflect people’s perceptions of inflation, both now and in the future,” Utley points out. “Remember, if you’re trading, there’s a good chance you’re either buying your securities from a professional or selling your securities to a professional. The markets know more than we think they do.”

If there are losses in the portfolio due to inflation, will this have a substantial negative impact on the retirement income distribution strategy? A lot depends on the current portfolio, age of the physician and the life expectancy, says Pratt. An analysis of the goals may reveal changes are needed to the portfolio.

“Short-term bonds can be a good place to hide when riskier assets are plummeting,” notes Joyce.“But in a rising inflation environment, bonds can result in poor investment performance. It is good to focus on long-term goals and objectives and maintain a diversified portfolio that can provide for both security of principal in the short term and portfolio growth in the long term. In other words, to be able to sleep at night now but eat better in 10 years.”

Balance risk versus reward

Many financial paths can be followed through unknown market conditions and higher interest rates. Mutual funds or individual stocks? Real estate? Bonds? Something else? Experts say what’s most important is understanding the risks and rewards of each option and how they compare to financial goals and the investment timeline.

For example, mutual funds might be seen as a safer choice than individual stocks, but that’s not necessarily always the case.

“Mutual funds can insulate (investors) from single stock risk, but diversified portfolios can also be constructed using individual stocks, bonds, real estate and nontraditional investments whose returns, (which) are somewhat uncorrelated with each other, can also insulate a portfolio from purchasing power risk,” says Joyce.

Pratt points out that a portfolio with multiple mutual funds has its own set of risks to consider. “If one share of an S&P 500 index fund is purchased, the underlying exposure carried is spread across roughly the largest 500 companies in the U.S. economy,” he says. “If you layer in other funds across mid- and small-sized companies as well as overseas (funds), a portfolio can quickly be built with underlying exposure to potentially thousands of different individual companies. Is this better than owning individual stocks? Maybe, maybe not.”

Each investor has to establish their own timeline and risk tolerance level to help them navigate through changing market conditions.

“For any investor, whether it’s inflation or something else, the broad scope of current economic conditions should be considered in relation to how investment portfolios are allocated,” says Pratt. “As economic conditions change, as well as individual circumstances of investors themselves, portfolios should be reviewed and adjusted as needed to ensure proper alignment of goals and time horizons.”

For example, a physician approaching retirement who is heavily invested in stocks may want to consider reducing risk in their portfolio by increasing bond exposure. A physician who is young and doesn’t plan on retiring for 30-plus years may not need to do the same, says Pratt.

Younger physicians may be wise to simply ignore inflation and focus on making the right financial moves, says Utley.

“Young physicians should be buying a home, whose value tends to rise with inflation, and owning a diversified portfolio that’s tilted heavily toward equities, whose returns tend to outpace inflation. Basically, if young docs are making smart moves with their money, they’re already taking the right steps to weather inflation.”

But it still comes down to risk tolerance. Even though a younger physician has a longer investment timeline and can take a more aggressive investment strategy, that might not be something they are comfortable with,” he says.

If that’s the case, experts say they should take a less aggressive approach that matches their comfort level.

Understand the big picture

The day-to-day market changes and news cycles can affect stock and bond prices. But physicians should not be investing based on what headlines they are reading. For example, the Russia-Ukraine war generates a lot of news, but it has had little actual impact on market performance.

Pratt says Federal Reserve policy will continue to be the primary driver of market returns in the near term, particularly in the fixed-income space. “While bonds are an important risk management role within diversified portfolios, their prices — and performance — are negatively correlated with interest rates, meaning they are likely to see continued volatility as rates rise,” he says. According to the CME FedWatch Tool, market participants are currently pricing in an 86.4% probability of the federal funds rate rising by an additional 2.5% by the end of 2022. “If the Federal Reserve signals a more aggressive approach than currently expected, fixed income markets could come under further pressure; conversely, a dovish shift could lead to a rebound.”

Utley points out that inflation isn’t the biggest risk to a physician’s finances. “The things that clobber docs are entirely within their control,” he says. “The triumvirate of physician destroyers are a nasty divorce, running a small practice into the ground, and failing to save enough for retirement.”

In addition to those things, he says too many doctors are making mistakes with their student loans around public service loan forgiveness. “It’s costing them literally hundreds of thousands of dollars, often the equivalent of five or ten more years of time on the job, in the clinic, working harder than they have to,” says Utley.

Inflation might get most of the headlines, but that doesn’t necessarily mean it should be the guiding factor in all investment decisions.

“As with any investment portfolio related approach, it’s important to consider the whole puzzle and not just one piece of it,” says Pratt. “Some folks may be more impacted in their investment portfolio by inflation while others not so much. Every investor likely has goals, time horizons, risk tolerances and investment preferences unique to them, so take these considerations into account and be sure to maintain proper diversification that matches the investor’s specific time horizons and risk tolerance.”

What to do with those variable-rate loans?

Low interest rates enticed a lot of people, including physicians, to take on more debt than they probably should have. A new house, new car, new boat — all sound great with cheap financing and a low interest rate.

But some of those loans may have variable rates, which are increasing as the Federal Reserve continues to raise rates to counter inflation. Each time the rate goes up, so do all those loan payments. Should physicians be looking to refinance variable-rate loans into fixed-rate loans?

“In general, loans on assets that will decline in value, such as boats and cars, should be paid down or paid off,” says Michael Joyce, CFA, CFP, president of Agili. “Homes will generally increase in value and can be leveraged. Always be careful about refinancing costs, which can rapidly eat up any interest rate savings.”

W. Ben Utley, CFP, president and a primary advisor with Physician Family Financial Advisors, says that now is a good time to refinance variable rate loans to fixed rate loans, but one thing needs to be kept in mind. “Having debt is a good thing during inflationary times,” he says. “You borrowed with 2022 dollars and you’ll be repaying with dollars from 2023, 2024 and beyond, and all those future dollars are worth less than they would be if there were no inflation.”

If a loan has a short payback timeline of only a few months, Jeff Pratt, CRC, a financial advisor with Finity Group, says there probably isn’t a need to refinance. Although physicians may also be tempted to try to quickly pay off fixed rate loans with low interest rates, this might not always be the best option. For example, if the loan rate is 2%, taking the extra money that would be used to pay off that loan might be better allocated into the stock market where that money might yield a better overall return.

“Risk tolerance in the stock market can also play a role in determining how best to approach debt repayments as someone who believes they can average an 8% return in the market is likely going to address their debt package differently than someone who believes they can only average a 5% return in the market,” says Pratt.

For those with multiple debts with different interest rates and loan types, Pratt says the most efficient way to pay them down is to rank them by their after-tax interest rates and pay the minimum due on all of them expect for one — the debt with the highest interest rate — and pay extra on this one to accelerate its repayment. Once the highest interest debt is paid off, then apply the amount you were paying on the original highest interest rate debt toward the balance on the next highest rate, and so forth.

“Mathematically, this will minimize the total amount of interest paid over the life of all debts on a balance sheet as we’re considering the opportunity cost of each unique debt carried,” says Pratt.