Jim'sMoneyBlog

Financial Opinion and Insights

Inflation is Sneaky – The Hazards Are Huge

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Inflation is like glaucoma.  You can’t see it on a day-to-day basis, but the erosion of purchasing power is still there.  Do you remember when $50,000 a year was a lot of money and $5,000 would buy a luxury car? 

My dad retired in 1974 and lived 32 years in retirement!  Suppose he had $800,000 on the day he retired and someone had sold him a guaranteed 5% investment that would pay him $40,000 annually for the rest of his life.  It would have looked good to many people in 1974; but after 20 years of inflation, that $3,333 per month—BEFORE taxes—wouldn’t have looked so good… and he would live more than another decade!

Consider a 54-year-old widow who puts $2,500,000 into a guaranteed fixed-income investment yielding 4%.   A $100,000 a year income sounds pretty good and the money is considered safe!  But, let’s examine the situation in the real world.

The Impact of Inflation

Widow, age 54, 30-year life expectancy

4% Interest Rate

3% Inflation Rate

$2,500,000 invested

                     (A)                                   (B)                    (C) = A x B

Capital      Interest                   Real

Year          Purchasing Power     Rate               Yield

Now          $2,500,000                        4%                   $100,000

10             $1.860,235                        4%                   $  74,409

11             $1,384,189                        4%                    $ 55,368

12             $1,029,967                        4%                   $  41,199

Source: Asset Allocation, Roger C. Gibson, McGraw Hill, 4th Edition.

 

Notice the chart above which shows what really happened.  Her `safe’ money  was worth less and less  – and the same thing happened to the purchasing power of her income from interest.  At twenty years, with still a decade ahead of her, her income was worth just over half what it used to purchase and the same was true for her principal.   And, we didn’t even factor-in taxes.  That would be too scary.

Was this income certain?  Yes.  Was the outcome certain?  Yes, that too.  And, buy the way, what if inflation and taxes didn’t stay the same?    I’m getting beyond the scope of this piece, but you get the idea.

When it comes to stocks, investors seem to be hurt more by their behavior than their investments.  DALBAR, Inc., a Boston-based firm that provides research to the financial industry published an often-cited study entitled, “Quantitative Analysis of Investor Behavior”, comparing the track-record of the average investor in equity mutual funds to that of the S&P Index of U.S. large company stocks for the 20-year period between 1986 and 2005.  Based on the timing of contributions to and withdrawals from equity mutual funds, the average equity mutual fund investor earned just 3.9% while the S&P Index had an average annual return for the same period of 11.9%.  The major reason:  Investors chasing performance, which by definition is always past.

So, how does the average investor protect against inflation and taxes while still not exposing her portfolio to an unacceptable level of volatility?  The answer lies in the asset allocation that results from a properly researched and constructed plan.   You can request my paper on The Asset Allocation Process by using the `Request Info’ button on the IFG website.

Jim

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Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.