They’re back…termites and inflation? Termites can be as devastating to your home as inflation can be to your investment assets. Both are difficult to detect and can be extremely destructive if not dealt with early. Termites hide in your walls and foundation and eat away at your home’s skeleton leaving it precariously unsound. But if discovered early, termites can be eradicated. Inflation, if not detected early, can destroy one’s financial foundation. But putting the right investment program in place can mitigate the destructive force of inflation and ensure one’s financial well being.

Inflation is defined as the rise in the general level of prices of goods and services in an economy over a period of time. Inflation erodes purchasing power or the value of a country’s currency per unit of goods or services purchased. As an example, McDonald’s first hamburgers in 1955 cost .15 cents each. Today that McDonald’s hamburger (which has not changed much) costs just shy of $1.00. Over 56 years, that is about a 3.5% per year increase. That increase is what economists call a sustainable inflation rate because the US economy (and wages) grew at approximately the same level over that same time period. But what happens when inflation out paces sustainable growth? Just take a look at what happened in Brazil during the 1970’s & 80’s. In that country a staple of daily life, a loaf of bread, increased 100 percent (or more) in price in just about every year.  Imagine today a loaf of bread costing $2.50 at the beginning of the year and costing $5.00 by the end of the year. This type of runaway inflation wrecked havoc on the Brazilian economy and eroded individual Brazilians’ wealth. In the end, much like a house infested with termites, the Brazilian economy collapsed along with the wealth of its citizens.

Inflation has been back in the news again as the cause for rising commodity prices that impact the cost of food and energy we all consume. The recent unrest in the middle-east has been blamed on inflationary effects among other things. So with the threat of inflation rearing its ugly head again here in the U.S., will the Federal Reserve (Fed) play the exterminator? Probably not. The Fed’s track record for causing inflation is almost perfect, but its record for stopping inflation is sketchy at best. So what can you do? Well, with some thoughtful understanding and careful planning, your investment portfolio can be shielded from the impact of modest moves in inflation. For those individuals that rely on receiving a fixed income such as alimony, annuity income, or the like need to take special note because inflation is a purchasing power killer.

Investment portfolio diversification is the key to offsetting the effects of inflation. As an example, let’s assume your investment portfolio provides only a fixed income (such as an alimony) payment of $10,000 per month (or $120,000 per year). If your expenses are $80,000 a year, at 3% inflation it would take just 15 years for your expenses to outpace your income. At 6% inflation you would be in a deficit in only 8 years and a major lifestyle change would be required. The U.S. inflation rate has averaged approximately 3% over the last century. So you may think 6% inflation is unrealistic, but from 1968 to 1987 inflation averaged just over 6%.

Many individuals find comfort in receiving a fixed income especially after a major life event such as divorce or retirement. But as previously shown, a fixed income means you are inviting the inflation termites into your financial foundation. Creating an investment portfolio with a diversified group of asset classes, market capitalizations (size), and geographies provides the best defense against inflation. Diversification also has the added benefit of reducing the volatility (or ups and downs) in the portfolio. This type of diversified portfolio produces what is called “total return”. Total return is achieved from capital gains, interest, and dividends rather than from just interest typical of a fixed income (or annuity) portfolio. Each individual is unique and has their own set of circumstances and risk tolerances, so careful planning and monitoring of your individual diversified portfolio should be considered.

Selecting a fixed income such as alimony or an annuity as your primary source of support may provide a level of comfort initially, but in the end, not even the exterminator can protect your financial foundation, like a diversified portfolio, from the ravenous effects of inflation.