Section II - Lesson 5E
Investing Basics - Understanding Risk: Inflation Risk
Your real risk during a 50-year investment program is clearly inflation, and the only way to beat inflation is to own common stocks, which have a tendency to appreciate as prices increase. Otherwise, in fixed income investments, your purchasing power shrinks from year to year and you wind up with less “real” income than you expected.
Let’s look at the following table which deals with real rates of return, after adjustment for inflation, for four major categories of securities, and we’ll see why we have little other choice but to invest in common stocks for a long-term investment program. The table shows approximate net returns since 1926.
|
Type Fund |
Average
Return |
(Inflation) |
Net Return |
|
|
|
|
|
|
Common Stock |
10.5% |
(3.0%) |
7.5% |
|
Balanced
(50/50) |
7.5% |
(3.0%) |
4.5% |
|
Bonds |
5.0% |
(3.0%) |
2.0% |
|
Cash Reserves |
4.0% |
(3.0%) |
1.0% |
Inflation has persisted at an average annual rate of 3% since 1926, and when we allow for that, the table shows that our net return on anything but stock related investments is, to put it mildly, pretty lame.
When you understand the nature of inflation risk, you'll want to manage your money rather differently from the way your parents and grandparents were taught to manage money. If they were taught at all, they were instructed to put their money, at retirement, into short-term U. S. government bonds, or insured certificates of deposit, and to then live off the low fixed income from these securities, taking care to “never, ever touch the principal.”
This was depression era “wisdom.” The idea was that if you never touched the principal you’d perpetuate your meager income and die with the same amount of money that you started with. Sadly, this philosophy did not take into account the effects of increasing life expectancy, the ravages of inflation, and the opportunities created by new and better investment products such as market index funds.
In the 1930’s and 1940’s life expectancy was considerably shorter than it is today. It’s said by cynics that the reason that 65 was picked as the “normal retirement age” by corporations and the Social Security System was that people were generally not expected to live that long, and certainly not much longer.
Inflation could not rip you up too badly if you only lived for a few years after retirement. People opted for fixed income from a pension plan to go along with Social Security benefits and whatever interest they could muster from their savings. Nowadays, however, we live well into our 80’s and 90’s, thanks to advances in medical science. Would you really want to try to live for 25 or 30 more years beyond retirement age on a "real return" of 2% from a government bond portfolio?
Fifty years ago postage stamps were 3 cents apiece, phone calls were a nickel, and a cup of coffee was a dime. The quarter million dollar house I live in was bought for $13,500. Inflation raises havoc for anyone on fixed income, causing him or her to require more and more income over time, and the income simply is not available. Six percent of someone’s $100,000 CD remains $6,000 per year no matter how long he lives, while the purchasing power of this amount of money continually diminishes. If you expect to live 15 to 25 years beyond retirement you'd better own some common stock funds.
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