Inflation's Effect on Portfolios
A very good article on the effects of inflation on portfolios published over at a blog I've started reading called Abnormal Returns. {Excerpt with highlights and a comment at the end.}:
Inflation is Still the Silent Killer By Tadas Viskanta
The goal of every investor is to generate real, after-tax returns. Pretty simple stuff. The financial media spends most of its time talking about nominal returns. In a very real sense inflation and taxes play just as important a role on investor outcomes. We don’t spend a lot of time talking about inflation rates and tax laws because the evolve much more slowly than market returns. Therefore our attention is drawn to market returns which as we all know are volatile. It therefore is easy for investors to become complacent about inflation. (Let’s leave aside taxes for this discussion.) Ever since the end of rampant inflation in the 1970s and early 80s, inflation by and large has been off the table as a issue for investors and the economy.....
....This view of inflation unfortunately misses the bigger picture. 2%, let alone 3%, inflation over the lifetime of an investor compounds at a pretty good clip. Mebane Faber at World Beta in the chart below shows the difference between a 9.4% nominal return and the returns less 3% inflation. As you can see the difference this makes compounded over a lifetime of investing.
Faber goes on to talk about the challenge inflation poses to investors in balanced portfolios, let alone those trying to make a go of things in cash equivalents:
"Even investing in a 60/40 portfolio is only expected to return around 3% a year in real terms while STILL exposing investors to 70% losses. These strategies should all be seen as simply strategies to keep up with inflation. That is depressing of course, but true. The worst outcome is the cash under the mattress strategy which will expose the investor to anywhere from 2% to 7% losses per year. You may not notice the effects, kind of like a boiling frog, but at some point you look back and say, “wow, I remember when a Coke cost 25 cents….”
A lot of investors these days are holding large cash balances in the hope of riding out current market volatility. The problem is with the return on cash hovering around 0% in nominal terms and -2% in real terms, if you believe the inflation expectations, this puts investors in a pretty deep hole......Inflation never really went away as an issue for investors. What went away are decent, low-risk options to try to keep up with inflation. The Fed’s policy of zero interest rates has made difficult choices for investors. Unfortunately no let up seems imminent. All the while inflation is still the silent killer of investor portfolios, compounding away in the background.
My Comment: Many investors are afraid of the market volatility which has increased in recent years. They automatically look for ways to avoid this and still have some sort of nominal rate of return after inflation. They most often look to what is perceived to be risk free investments such as government bonds or less risky investments like other bond instruments or annuities. In my mind there are two issues here. The first is that many of these so called risk free or less risky investments turned out to be much more dangerous than people thought. There are many folks that purchased annuities today for example that have no idea how close some of the underlying companies that guaranteed these investments came to going out of business in the 2007-2009 period. Often as with annuities, they also pay substantial real and hidden fees for this perceived level of protection that eats away at what they might otherwise have been able to have saved.
The second issue is what price people are paying for this so called security. A 10 year US Treasury bond today yields 2.06%. A 2 year piece of the same paper pays 25 basis points {1/4 of 1%}. Money market accounts are worse, basically yielding nothing. On an after tax basis and assuming a 2% inflation rate, investors are basically losing money by losing purchasing power when they hold these investments. As an aside and as I've noted before, when you hold a piece of paper that basically gives you the right to lose money via purchasing power for 10 years, you are basically saying that you have so little confidence in economic prospects over the next decade that you are willing to lose money slowly for the chance to get back all of your principal amount {absent its loss of purchase power} on some distant date.
I understand people's concerns and current distrust of stocks and I'm not advocating that every bit of a person's assets should necessarily be tied up in the markets. But many people need to gain some balance and perspective about this issue which judging by the trillions of dollars locked up in money markets is still sorely lacking by investors.
Finally as an aside the one thing forgotten by investors is that money markets, {unless they are backed by government securities} are not normally guaranteed by FDIC and they are run by investment companies in the business of making a profit. The yields are so low on money markets right now that many firms make no money on these and run them simply as a courtesy to clients who invest in other higher yielding funds with these firms. If rates stay low into perpetuity look for firms to try to find ways to make money off of these accounts or perhaps get out of that business entirely.
My Comment: Many investors are afraid of the market volatility which has increased in recent years. They automatically look for ways to avoid this and still have some sort of nominal rate of return after inflation. They most often look to what is perceived to be risk free investments such as government bonds or less risky investments like other bond instruments or annuities. In my mind there are two issues here. The first is that many of these so called risk free or less risky investments turned out to be much more dangerous than people thought. There are many folks that purchased annuities today for example that have no idea how close some of the underlying companies that guaranteed these investments came to going out of business in the 2007-2009 period. Often as with annuities, they also pay substantial real and hidden fees for this perceived level of protection that eats away at what they might otherwise have been able to have saved.
The second issue is what price people are paying for this so called security. A 10 year US Treasury bond today yields 2.06%. A 2 year piece of the same paper pays 25 basis points {1/4 of 1%}. Money market accounts are worse, basically yielding nothing. On an after tax basis and assuming a 2% inflation rate, investors are basically losing money by losing purchasing power when they hold these investments. As an aside and as I've noted before, when you hold a piece of paper that basically gives you the right to lose money via purchasing power for 10 years, you are basically saying that you have so little confidence in economic prospects over the next decade that you are willing to lose money slowly for the chance to get back all of your principal amount {absent its loss of purchase power} on some distant date.
I understand people's concerns and current distrust of stocks and I'm not advocating that every bit of a person's assets should necessarily be tied up in the markets. But many people need to gain some balance and perspective about this issue which judging by the trillions of dollars locked up in money markets is still sorely lacking by investors.
Finally as an aside the one thing forgotten by investors is that money markets, {unless they are backed by government securities} are not normally guaranteed by FDIC and they are run by investment companies in the business of making a profit. The yields are so low on money markets right now that many firms make no money on these and run them simply as a courtesy to clients who invest in other higher yielding funds with these firms. If rates stay low into perpetuity look for firms to try to find ways to make money off of these accounts or perhaps get out of that business entirely.
posted by CR English at 7:32 AM
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