Inflation is one the most insidious risks investors face, for two reasons: 1) it’s unavoidable and 2) it’s easily overlooked.
Inflation Reduces Purchasing Power
At an annual rate of inflation of 3%, a loaf of bread that cost $3.00 last year costs $3.09 this year. That doesn’t seem too bad. In fact, since 1926, the U.S. has experienced an annual rate of inflation of 3%, which is deemed a healthy rate for economic growth.
The other way to look at that 3% hike in prices is that the dollar you owned last year is now worth just 97 cents. Again, that alone doesn’t seem like a big deal, until you compound that rate over time. After 10 years, at that same rate of inflation, a dollar is worth 74 cents; after 15 years, it’s worth just 64 cents; and after 25 years, it’s worth only 48 cents.
Inflation Dwindles Investment Returns
Financial experts and economists make a distinction between nominal and real or inflation adjusted growth. Nominal growth means that if the market value of your IRA rose from $100,000 to $103,000, it grew by $3,000, or 3%. But if the prices of all goods and services also rose 3%, your real return was 0% — inflation discounted every penny of growth you earned.
The Implication for Investors and Retirees
The direct implication for investors is the need to account for inflation in their financial plans. The way financial advisors do this is to either 1) state your goals in present dollars (i.e., don’t adjust them for the effects of inflation) and subtract an assumed rate of inflation from your expected return; or 2) state your goals in future dollars by compounding your current expenses by the assumed rate of inflation, and use your nominal rates of return to project your future asset values.
To deal with inflation, investors and retirees may require some adjustments in how they invest or must reduce their life style costs in retirement. Since historically stocks have been the best way to keep your investment assets growing faster than inflation, even the most conservative investors may need to keep a healthy percentage of their portfolios invested in stocks.
The investor who thinks he’s avoiding risk by staying out of the stock market is ignoring inflation risk. Without some offset for the eroding effect of inflation, such ultraconservative investors virtually guarantee that the longer they live, the less purchasing power they will have.
Does your financial plan take inflation into account or are you already retired and withdrawing as much or more than your portfolio earns to support your lifestyle? These are absolutely essential questions to address.
Please call if you’d like to discuss inflation and your financial plan in more detail.