Should my investments change based on personal inflation?

Should Your Investments Change Based on Personal Inflation?

Inflation is a financial phenomenon that affects everyone, but it doesn't impact each of us equally. When we talk about inflation in our personal finances, we're referring to how the rising cost of living💡 Definition:Amount needed to maintain a standard of living affects our unique situation. You might wonder whether your investments should change based on your personal inflation rate💡 Definition:General increase in prices over time, reducing the purchasing power of your money.. Understanding how to adjust your investment strategy in response to personal inflation can help ensure your financial growth outpaces the cost of living.

Understanding Personal Inflation

Personal inflation is how rising prices affect your individual expenses. For example, if you spend a significant portion of your income💡 Definition:Income is the money you earn, essential for budgeting and financial planning. on healthcare and medical costs are rising faster than the average inflation rate, your personal inflation rate could be higher than the national average. This personalized rate varies based on lifestyle, spending habits, and location.

To illustrate, consider two individuals:

• Person A lives in a city with a high cost of living and spends extensively on dining out and entertainment.
• Person B resides in a rural area, grows their own food, and spends more on home maintenance.

Their personal inflation rates will💡 Definition:A will is a legal document that specifies how your assets should be distributed after your death, ensuring your wishes are honored. differ significantly, affecting how they should consider adjusting their investment strategies.

Aligning Investments with Personal Inflation

If your personal inflation rate exceeds the national average, you should consider adjusting your investment strategy to ensure your returns outpace your cost of living. Here are some steps to consider:

1. Calculate Your Personal Inflation Rate

To calculate your personal inflation rate, track your expenses over a year and categorize them. Analyze how each category’s costs have changed compared to the previous year.

• Example: If your total expenses last year were $50,000 and this year they increased to $52,250, your personal inflation rate is 4.5%.

2. Set a Target Return Rate

Based on your personal inflation, aim for investment returns that provide real growth. If your personal inflation rate is 4.5%, targeting a return of 7.5% to 9.5% can offer a real growth of 3% to 5%.

• Example: To achieve a 7.5% return, you might need a higher allocation in equities, which historically offer higher returns but come with increased risk💡 Definition:Risk is the chance of losing money on an investment, which helps you assess potential returns..

3. Adjust Your Asset Allocation💡 Definition:The mix of different investment types in your portfolio, determining both risk and potential returns

Consider adjusting your asset allocation to align with your new target return rate. Typically, this involves increasing your equity💡 Definition:Equity represents ownership in an asset, crucial for wealth building and financial security. exposure, which can help achieve higher growth.

• 💡 Definition:Risk capacity is your financial ability to take on risk without jeopardizing your goals.Risk Tolerance💡 Definition:Your willingness and financial ability to absorb potential losses or uncertainty in exchange for potential rewards.: Ensure your allocation aligns with your risk tolerance and investment horizon💡 Definition:The period until an investment goal is reached, influencing risk and strategy.. Younger investors might handle higher volatility💡 Definition:How much an investment's price or returns bounce around over time—higher volatility means larger swings and higher risk. better than those nearing retirement💡 Definition:Retirement is the planned cessation of work, allowing you to enjoy life without financial stress..

Real-World Investment Adjustments

Let's consider a practical example:

• Current Portfolio: 50% equities, 40% bonds💡 Definition:A fixed-income investment where you loan money to a government or corporation in exchange for regular interest payments., 10% cash
• Personal Inflation Rate: 4.5%
• Target Return: 8%

To achieve an 8% return, you might adjust to:

• New Portfolio: 70% equities, 25% bonds, 5% cash

This shift reflects a higher risk tolerance and aligns with your personal inflation needs, assuming a long-term investment horizon.

Common Mistakes and Considerations

1. Ignoring Personal Inflation

Many investors focus solely on national inflation rates, overlooking personal spending patterns. This oversight can lead to insufficient portfolio growth.

2. Overreacting to Inflation

Adjusting your investments isn't about drastic changes but measured responses. Overreacting by excessively altering your portfolio can introduce unnecessary risk.

3. Neglecting Diversification💡 Definition:Spreading investments across different asset classes to reduce risk—the 'don't put all your eggs in one basket' principle.

While targeting higher returns, ensure your portfolio remains diversified. Concentrating in a single asset class💡 Definition:A group of investments with similar behavior, risk, and regulatory profiles (e.g., stocks, bonds, cash). can increase risk without guaranteeing higher returns.

Bottom Line

Adjusting your investments based on personal inflation can help maintain or grow your purchasing power💡 Definition:The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. over time. Calculate your personal inflation rate, set a realistic target return, and adjust your asset allocation accordingly. Remember, your investment strategy should also reflect your risk tolerance and time horizon.

By staying informed and making thoughtful adjustments, you can better position your portfolio to navigate the challenges of personal inflation, ensuring your financial well-being in the long run.