The Consumer Price Index, personal consumption expenditures, and other measures don’t necessarily capture the full effects to your personal expenses
Inflation varies from person to person due to factors such as geography, personal demographics, and so-called “hedonic adjustments”
Consider looking at your investment objectives through a “personal inflation” lens
Inflation is a tricky thing, especially when trying to compare national data to your personal outlays. The Consumer Price Index (CPI), personal consumption expenditures (PCE), and other measures of inflation may be fine on the aggregate level, but what about the personal level? Perhaps everyone should create their own inflation index—call it the YPI for “your personal inflation.”
What do we mean? Let’s unpack.
The Bureau of Labor Statistics (BLS) said in mid-February 2021 that prices for the basket of goods and services it uses to track inflation rose 0.3% in January, while core prices—which don’t include often-volatile food and energy prices—were unchanged. Over the last 12 months, the agency said both figures were at 1.4%.
The agency strips out volatile products like food and energy to get a more consistent read on rising prices. That’s fine for economists, but at last check, people still eat and drive—and these activities often make up a big chunk of monthly expenses. So, yes, our personal inflation rates are different.
Behind the headline numbers, the BLS tracks prices on a number of things—from underwear to airline prices—to suss out inflation. It compiles these goods and services into eight major groups including food and beverages, housing, medical care, education, and others.
Over the years, the BLS changes how it tracks inflation based on what goods and services we use and the quality of those items, including what it calls a “hedonic adjustment,” an eyebrow-raising economic term if there ever was one. What that really means is adjusting prices for a “pleasurable” product or service changed by innovation or obsoletion. (Leave it to economists to make hedonism sound boring.) Clothing, phones, and internet services all fall under the hedonic adjustment, as do appliances and TVs.
These hedonic adjustments often don’t capture real life. For example, a recent report from UBS showed landline costs have fallen sharply as a total of personal spending, but when was the last time you used a landline—if you still have one? UBS reported the amount we spend on cable is declining to just below 1%, but video streaming is rising, having gone from 0.2% in 2000 to nearly 0.4% in 2020, and will likely continue to rise.
These examples should help you see there’s the “official inflation” rate and then there’s “your personal inflation” (YPI) rate. For saving and investing, focusing on your expenses and beating your inflation rate is key to meeting your financial goals.
Your personal demographics—that is, your family earnings, where you live, and what you spend your money on—determines your personal basket of goods and services.
Viraj Desai, senior portfolio manager at TD Ameritrade, noted CPI data for housing and what goes into it makes up 42% of the basket. But where you live—a major city like Chicago versus a smaller city like Charlotte, North Carolina—will determine your housing expenditures and how fast those prices rise. Although housing costs are up everywhere, the pace of those gains were sharpest in major cities.
The same goes for medical care, education expenses, communication services, and other areas many people spend their money on. To get a grip on both your spending categories and how those prices have changed, review your budget and compare it to the BLS categories, Desai suggested.
Though it’s likely your personal basket will be different—even higher—than the BLS data, one useful takeaway is to look at the direction of price increases (or decreases) and the frequency of those expenses in your basket. Yes, TV prices might be down 90% from 10 years ago, but how often do you buy a TV? How does your cable bill reflect what you spend for it now? If you cut the cord, what spending has replaced it?
Looking at your personal inflation rate is a different way of understanding your expenses and how to adjust saving for goals, such as education, the cost of which has significantly outpaced inflation in any measure.
“It could be a call to action,” Desai said. “If you see that your inflation rate is so massive, where are there opportunities to reduce spending to save incrementally more?”
WIN-ning the Inflation/Investing Game
When inflation was high in the 1970s, the Ford administration passed out “WIN” buttons, an acronym for “Whip Inflation Now.” You can create your own person “WIN” through portfolio construction to preserve the purchasing power of what you’ve earned. Part of investing is beating inflation.
Desai explained that when investing for long-term goals of 10 years or more, where expenses are rising faster than inflation (such as higher education and medical costs), there’s a higher hurdle rate—the minimum rate of return required to meet the goal. Weighing your personal CPI basket (or “YPI” if you prefer) against your savings goals—while keeping inflation in mind—can give you another way to think about investing to meet those goals.
In pursuing those goals, you might consider tweaking your risk tolerance by, for example, upping your allocation to growth-oriented equities in an attempt to outpace inflation.
Conversely, inflation rates may not matter as much for short-term goals, or those where money is needed in five years or sooner, because market volatility may have a greater impact than inflation.
Like anything, investing is a balancing act of trying to limit exposure to market volatility in the short term while still managing investments for the long term to beat inflation.
In the end, especially when it comes to a long-term goal like retirement, things like protecting purchasing power and accumulating assets to keep a standard of living intact is another way to reflect about how and why you’re investing. And it can help you set appropriate savings, spending, and risk tolerance levels.
There’s no guarantee you’ll WIN in the end, but understanding YPI—and taking steps to manage it—can help you see the bigger picture regarding your investment objectives.