Investments

November 24, 2015 / Timothy Grove

Inflation: The Slow, Sneaky, Silent and Stealthy Portfolio Assassin

Perhaps inflation is not quite as certain as death and taxes, but it is up there.  We all know that things cost more now than they did in the past, and the longer one’s memory is the more pronounced that difference will be.  A handy tool for seeing the effect of inflation is this calculator from the U.S. Bureau of Labor Statistics, where one can enter a dollar figure and a year, and calculate the inflation-adjusted equivalent today (or any other year).  So if history is any guide, goods and services will cost more in the future than they do now, and the magnitude of that increase will be directly proportional to the amount of time that passes.

So how does inflation relate to our investments?  We all enjoy looking at our statements and seeing that we have more money now than we did at some point in the past.  But the question we need to ask is:  how does the purchasing power of that money today compare to its purchasing power at that point in the past?  After all, what good is money if it cannot purchase the goods and services necessary to at least maintain a desired standard of living?

Keep in mind that the rate of return we see on those statements is the nominal return; that is, unadjusted for inflation.  To see the change in purchasing power, one has to calculate the real return by subtracting the inflation rate from the nominal rate.  There is a more precise calculation of inflation-adjusted return, but this simple method provides a very close approximation.

As investors, we tend to fear (and overreact to) a sudden downturn in the market which puts a dent in the value of our portfolio; this makes us want to run to “safe” investments like cash and bonds.  It’s true that investing more aggressively than is appropriate puts us at risk when there is short term market volatility but we have to remember that there is also a risk to investing too conservatively-the risk that our assets will not return enough to keep up with inflation and will thus lose purchasing power slowly but inexorably as time passes.  And unlike short-term market volatility, the risk of purchasing power being lost to inflation becomes greater as an investor’s time horizon gets longer.

During our working years, inflation isn’t generally a great concern as wages have historically tended to keep pace with inflation; plus an individual’s salary tends to increase over time commensurate with increases in his or her skills and experience.  But it’s a different story when we retire and have to rely on our savings and investments to maintain our standard of living.  It’s no secret we are living longer than our ancestors. Thus, someone who retires at age 65 and lives to be 100 will spend 35 years in retirement.  That is a long time horizon and inflation should be a far greater concern to such an investor than any short-term downturn in the market.  Also note that the time horizon for one’s retirement investments is not the rest of his or her working years.  Rather, it is the rest of his or her life.

To illustrate, let’s say a retiree is withdrawing the typical 4% per year from his or her investment portfolio.  Over the past 50 years, inflation has averaged about 4% per year.  So if that continues to hold true, in order for this portfolio to maintain purchasing power after the withdrawals are made, it will have to have a nominal return of roughly at least 8% per year on average.  That is way too much to ask of a “safe” portfolio comprised of all bonds and cash!  Historically the only investments that have shown the potential return to keep a portfolio ahead of inflation are equities, and they must be a significant part of an investment portfolio so as to maximize the chance of maintaining purchasing power over time, especially when withdrawals are being taken.  When inflation comes into play, that “safe” all cash and bond portfolio suddenly isn’t so “safe” after all!

To add insult to injury, the IRS does not take inflation into account when it comes to the taxation of realized capital gains.  When a gain is realized, the amount subject to taxation is simply the value of the asset when sold minus its cost basis.  So the IRS is taxing “phantom” gains that were, in reality, lost to inflation.

One of my all-time favorite movies is Frank Capra’s 1946 Christmas classic It’s A Wonderful Life.  Being in the financial services field, one of my favorite scenes is when the villain, Mr. Potter (played by Lionel Barrymore) offers the protagonist, George Bailey (played by James Stewart) a dream job in an attempt to buy him off.  Potter offers George a salary that is so high in the stratosphere that George is instantly sent into a state of shock and drops his lit cigar into his lap, nearly setting himself on fire.  The salary?  Twenty thousand dollars a year!  Pretty laughable today but a rather respectable sum 70 years ago.

How respectable?  To see the equivalent in today’s dollars, complete the following exercise: in the BLS calculator given above, enter $20 as the starting value (the calculator doesn’t accept large numbers so divide by 1,000), select 1946 from the pull down menu and multiply the result by 1,000.  The result as of this writing is $244,050-nearly a quarter of a million dollars!  So, thanks to inflation, it would take $244,050 today to purchase what just $20,000 could purchase 70 years ago.  Using a financial calculator, this is an average annual increase of 3.64% over those 70 years-the approximate annual rate of inflation over that time period.

To put it another way, a $20,000 investment in 1946 would have had to earn an average annualized return of 3.64% over 70 years just to maintain its purchasing power.

While short term downturns in the market may grab the headlines, we must remember that, like a bolt of lightning and its accompanying clap of thunder, it is temporary.  But inflation, slow and imperceptible though it may be, has the erosive and unstoppable power of a glacier over extended periods of time.

 

Sources

4 Low Risk Inflation Strategies

CPI Inflation Calculator

Inflation and Its Effects on Investment

All About Inflation – Investopedia

Repeal the “Inflation Tax”

Finance Calculator

Inflation Adjusted Return – Investing Answers

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