Press "Enter" to skip to content

Inflation and It’s Impact On Your Portfolio

Over the years I have skirted around the concept of inflation and it’s impact on your portfolio.  Well, today I want to really focus on that impact.  It’s so easy to forget the impact on your investments, but it’s absolutely critical to understand when developing an investment strategy.

Defining Inflation

In prior posts I have explained how to determine and define inflation.  That post explained what inflation is, how to estimate inflation, and it’s impact on interest rates.  If you haven’t read it I would recommend pausing, taking a read, and then coming back to finish this post.  I’ll wait.

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 to early retirement?

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 Raman in retirement.

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 significantly in the direction of real estate.    Also, there is the question of which real estate market.  Where I live my home is still worth less than 2007.  But if you lived in some parts of California you might be swimming in appreciation.  So I guess the answer here is a definite it depends with a fair amount of risk.

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 inflation, if we are lucky. If born out, we would expect the risky assets of say the stock market to cover inflation over time plus a bit more.  Obviously real results would be dependent on the specific investment and situation.

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?

3 Comments

  1. Steveark
    Steveark February 4, 2019

    Great points, oddly the last year is one of the few times savings accounts, CD’s and money markets have kept up with inflation. 2018 CPI increase was 1.9% and the higher yield cash equivalents averaged close to that and now are paying 2-2.5%. I did keep some dry powder with equities overpriced and the longest bull market on record possibly losing steam and it did not lose value, but I agree it would over the long run.

  2. Mark
    Mark February 5, 2019

    Good post but over the long term bonds have kept pace with inflation and as interest rates rise so do the yields of bonds. Principal in bond funds decline but eventually the yields will make up for that decline. Since I am close to retirement, I only keep about 30% in stocks. I have been laddering bonds. The risk free premium is currently about 2.7 % which is also what the current inflation rate is. But the whole idea of Bonds is to reduce risk so yes bonds will have more trouble keeping pace with inflation but the risk part of the portfolio should help outpace inflation but as you rightly stated you can lose money in risk assets. The key is to strike a balance.

    • FullTimeFinance
      FullTimeFinance February 5, 2019

      The problem is, define long term. Look at the data mid-post from Fred (Fed Reserve St Louis). For almost the entire period from 2010 to present the 1-year treasury has lagged CPI. So even if we assume CPI does not under-report the last 9 years would reduce your money had you invested in short term bonds. Not pretty.

      I don’t disagree with the balance point. Timeline of fund need and amount needed would heavily influence actual allocation.

Leave a Reply

Your email address will not be published.