Over the years I have skirted around the concept of inflation and
I have also touched at a high level on why dry powder is a bad idea due to inflation. But just how bad are we talking? We talk about concepts like shifting more into safe investments as you move into retirement. But what about inflations impact on those investments over the long run? What is the impact
The Simple Example of Inflation and It’s Impact on a Portfolio
Well for today we’ll look at the most simple example. Imagine a hypothetical person, John Smith. Now for purposes of convenience, we are going to assume John saves 1 million dollars by his 35 birthday. We are also for simplicity sake going to assume John parks his 1 million dollars in cash from 35 to age 65, a period of 30 years. During this time he neither contributes nor withdrawals any money from his accounts.
Controlling for Inflation Alone
Admittedly this is a rather extreme construct, but it’s meant to really demonstrate how extreme the impact of inflation really is. So since John only holds his 1 million dollars in cash the only impact on his money is inflation. Inflation is obviously not a constant measurement. We have periods of what one might consider severe inflation like the 70s, and we have periods of relatively benighted inflation like recently.
Taking Two Periods On Opposite Ends of the Inflation Spectrum
So to make this fair we’ll take the two bounds. The first is the end of the most recent period. Inflation averaged about 2.42% a year over the last 30 years. That is 1988-2018. The inflation-adjusted value of 1 Million invested purely in cash in 1988 would be $492K. Not nearly enough for most to say retire on at 65 and live out the next 30 years. This is probably close to the best case scenario.
But what about one of the worst in recent memory, 1966-1995? The average inflation rate more than doubles to 5.52%. If you sat on that same million dollars during that period, it would be an inflation-adjusted mere $192K. Ouch, hello R
Extended Cash Investment is a Recipe for Disaster
So obviously cash for any extended length of time is a very poor investment. Essentially your investments at minimum need to return enough cash to offset inflation over time. Before we proceed with the analysis it is important to note, cash is also pretty much a synonym with any standard bank account. We’re not just talking about leaving money under the mattress. Most bank accounts, excluding the high yield savings ones online, earn a paltry point or two. You’d be lucky if you got .1% of a return. That return can’t begin to offset 2.4 % inflation a year, let alone 5%.
Defining the Options for Maintaining Value
No, you need something that can return greater than or equal to the rate of inflation over time. So in the most recent inflation period if you did not invest in something with a return greater then 2.4% over that period you were going backward. Worse if you didn’t beat 5.52% from the 60s to the mid-90s you went backward.
So what investment can consistently beat inflation? Well, I will give you a hint, it’s not bonds, savings accounts, or other risk-free investments. T-bills of the 1-year variety, for example, sometimes have a lower return than inflation, and sometimes higher. In fact, for much of the last decade, 1-year t-bills have returned less than inflation. So 1-year t-bills are a poor choice to offset inflation. What about t-bills of longer periods you ask? Well, the problem is a longer period bond would only help if you know what the inflation rate was going to be over the entire period. Otherwise, if inflation goes up and you locked into a 30-year bond, you wouldn’t be able to step up your interest rate to offset the added inflation. The simple point is cash and cash-like investments are a poor offset to inflation.
Precious Metals and Inflation
What about precious metals? Again probably not a good pick. Gold and inflation have a very poor correlation. Gold, as measured in real dollars, is down significantly since it’s hay day of 1981. The price of gold has risen much since 2000, sure, but it also spent the entire 2 decades before (the 80s and 90s) declining in real dollars. Inflation was quite healthy in the 80s and 90s compared to today with averages closer to 3% than 2%. Gold might be a good black swan hedge, but you can forget combating inflation with it.
Real Estate and Inflation
What about real estate? That is a tougher question to answer. There is some evidence that home appreciation and inflation run not far off in tandem after accounting for maintenance and depreciation. But the business of renting in addition to appreciation can tilt the dollars
The Stock Market and Inflation
What about the stock market? The average return of the US stock market has been about 7% depending on how you measure it. Obviously that handily beats the rate of inflation. But again it really depends on what market. I use the US as an example, but if you used Japan you’d be better off having left the money in cash. The odds may be in your favor investing in the US stock market but there is no guarantee. Past performance does not guarantee future results. Again the investment is not without risk.
Risk-Free Assets Can’t Consistently Beat Inflation
What about other investments to offset or beat inflation? There are as many investments under the sun as you can possibly conceive. Many of them probably do typically beat inflation. But, if you haven’t gotten the trend from the 2 items I’ve so far mentioned as possible to beat inflation, they involve risk. The key is if you want to consistently keep up with or beat inflation, you have to take risk with your investments.
This inherently makes sense. Money invested has a cost to invest. An inherent cost of the account tracking the money, the process of investing, the expense ratio, or what have you. In a riskless investment really the earnings need to pay that inherent cost plus your return. Meanwhile, really the driver of the riskless interest is inflation plus the expectations of inflation (as we discussed in the other post). As such we shouldn’t expect riskless assets to beat or match inflation over time in their return to you
Risk Premium’s Can Help to Meet or Exceed Inflation
Risky assets, however, receive a theoretical risk premium, inherent to the type of investment you are taking. So these investments will have a higher potential return then a risk-free investment, essentially the risk-free rate + that risk premium. That risk premium is what offsets
As such it becomes readily apparent for those with a long time horizon who will later need their assets, the only appropriate path forward is to invest a sizable portion (dependent on risk tolerance) in risky assets.
How do you invest to combat inflation? Were the numbers here a bit of a shock?