Inflation turns every investor into a loser
Reprinted courtesy of MarketWatch.com.
Published: August 24, 2016
To read the original article click here
As an investor, you can control lots of risks. But one of them, inflation, insidiously and silently steals your savings.
“Inflation is when you pay $15 for the $10 haircut you used to get for $5, when you had hair.” That’s what former baseball player Sam Ewing had to say.
Jay Leno said it like this: “I was reading in the paper today that Congress wants to replace the dollar bill with a coin. They’ve already done it. It’s called a nickel.”
Unfortunately, inflation is much more than a joke. Investment returns look very different after they are adjusted for inflation. Cutting deeply into the returns that investors think they have achieved or will achieve, inflation is a guaranteed loss that investors rarely worry about.
As I stated in my book Financial Fitness Forever, inflation risk is the very real danger that the money you save or earn will lose some of its purchasing power. Anybody who depends on fixed-income sources such as pensions and long-term bonds is exposed to this risk.
Even at a very modest rate of 3% annually, inflation can be a huge problem. You might retire on a fixed income of $50,000, which initially is more than adequate for your needs. But if your cost of living goes up 3% a year, after 25 years you will need $104,700 to replace that purchasing power.
If you would like to see the impact of inflation on your retirement investments over time, here’s a good online calculator. It will tell you how much income you will need in your first year of retirement and (this may be a shocker) how much income you’ll need in the presumed last year of your life.
This calculator isn’t a great tool for planning, but it certainly can be a wake-up call.
One thing the calculator (and in fact all accurate long-term planning) requires from you is an estimate of future inflation. This is a challenge.
In the early 1980s, investors and pundits were predicting future inflation of 5%, 6% or even more. That outlook seemed quite reasonable at the time, based on recent experience. From 1977 through 1982, the 6-year inflation rate was 9%. More recently, from 2010 through 2015, inflation was 1.5%.
For planning purposes, I suggest people think in terms of 3% to 3.5%.
Compound interest produces spectacular numbers over very long periods of time, as I recently demonstrated in an article last December about the effects of saving $1 a day, or $365 a year, for a child starting at birth and continuing until age 21. (Obviously, a child can’t do this, but a parent or grandparent can.)
That commitment may be the only way the child is likely to have what it takes to afford a comfortable retirement. A table in that article shows the impact of 8%, 10% and 12% earnings over 65 pre-retirement years and through a presumably successful retirement.
I think you’ll find the numbers pretty amazing: Total hypothetical returns from that modest investment were $2.6 million at 8%, $11.5 million at 10%, or $52 million at 12%. (The numbers include retirement distributions plus money left over for heirs.)
However, those huge future “inflated” numbers are just digits, meaningful only in context. Anybody who bought a home in the 1950s would be totally stunned by today’s prices, which we see as normal.
For example, I have a friend whose father bought a house in a small city in Washington state in 1951. The price, as my friend recalls, was $12,000. Today, according to Zillow, that home’s value is about $248,000. My friend’s father could never relate to that figure, yet it is “normal” to us.
When we’re planning for retirement, it’s best to think in terms of what really matters: what it will cost us to live in the future. Getting that information takes a bit of work, as I have described before. But if you’re willing to go through the exercise, you’ll wind up with a very good handle on what you should be doing now — and where inflation might fit into your long-term strategy.
So, the question remains: What can you do about inflation?
On the one hand, not much. On the other hand, quite a bit.
I don’t know of anything that ordinary folks such as us can do to influence inflation.
But on the other hand, we can limit the damage it’s likely to do to us.
Over more than 100 years, stocks have appreciated more than the rate of inflation. Not every year, and not every decade. But over the long haul, this pattern has been very stable, and I see no reason to believe that will change.
This is why I believe every investment portfolio, even for the most conservative investor, should contain some stocks. The question is not whether to include stocks, but what kinds of stocks and what proportion of stocks.
If you have read this far, you’re probably a serious investor. As such, you would undoubtedly benefit from reading the two articles in the links in that last paragraph.
In the meantime, you might want to get that haircut now. Before the price goes up.
I usually offer a podcast at the end of each article. But this week, perhaps in the spirit of inflation, I’m offering two! They are Part 1 and Part 2 of 20 things I think investors especially need to know most.
Richard Buck contributed to this article.
Purchase on Amazon
Sound Investing Podcast