It may come as a surprise to many investors, but the largest risk to their lifestyle in the long-term is the hidden and destructive impact of inflation through the loss of purchasing power. Investors tend to spend a lot of time focusing on the swings in investment market values caused by volatility, and because of this they may seek a ‘safe’ investment such as Bonds and CDs. The truth of the matter is that a portfolio made up of Bonds and CDs alone will not earn enough interest to keep up (let alone beat) inflation. A dollar today will not equal a dollar in ten years, and your money needs to be put to work in order to keep up.
Consider the chart below*:
Source: The Art of Asset Allocation, Second Addition, David Darst. McGraw Hill. Published by Morgan Stanley, 2008.
If you are retiring at age 65 today and inflation is running at 2% per year, after 20 years your ‘today’ dollar buys just 67 cents of value. At a 3% inflation rate per year (closer to the historical average), purchasing power drops to just 54 cents of today’s dollar. Another way to look at this is that it will take 1.85 times of today’s investment market value, on a pre-tax basis, merely to maintain purchasing power in 20 years.
Luckily, there are a number of easy ways to mitigate inflation risk.
Maintain flexibility in your cash outflows by limiting long-term obligations as well as floating rate debt. Make sure that your investment portfolios are diversified with asset classes such as equities and commodities (they tend to do well over the long run; keeping up with inflation through higher revenues, increased profits and larger dividends payments). Ensure that your fixed income portfolios, bonds, notes, and CDs alike, carry maturities along the interest yield curve.
The key to this issue is: Balance. We deal with market volatility nearly every day. Inflation is a more hidden and longer-term risk, but it cannot be ignored.