Inflation risk in investing is something nobody thinks about but one of the biggest threats to your investing goals
Most investors don’t realize it but inflation risk is one of your biggest hurdles to meeting your long-term investing goals. Even at low rates of inflation, your money halves in value every 30 years.
Thirty years is a long time. Why should you care?
Consider that you’ll be building your nest egg for about 30 years but that it will be worth half as much in today’s dollars when you’re able to retire.
Then imagine that your money is going to be half as much as that, just a quarter of its current value, towards the end of your retirement.
This is the second in our Intelligent Investor series, a 20-part series reviewing each chapter of the definitive book on value investing. Grab a copy of The Intelligent Investor on Amazon and follow the review to learn the investing ideas that taught Warren Buffett.
Our first article last week reviewed the problem of hot stocks and how to avoid gambling with your money.
This week, we look at chapter two and why inflation is the silent wealth killer.
- How inflation tricks investors into a false sense of security
- How investors may be deceived in the years to come
- How to invest for inflation and meet your investing goals
Inflation Risk and the Money Illusion
Inflation is the idea that prices increase for things each year because of wage increases and more money being created by the government. The economics are a little more complicated but the idea is that you buy less stuff for your dollars than you did the year before.
The problem with inflation risk in investing is that investors really don’t think about it. You often hear of the 7% annualized return on the market through the 20 years to 2010 but nobody talks about the fact that inflation averaged 2.65% over the period.
That means investors really weren’t making 7% a year because their money was losing nearly 3% of its value each year they weren’t spending it. The ‘real’ return over the period was closer to 4% on an annualized basis.
The graph shows reported annual returns on the S&P 500 since 1990 and the actual inflation-adjusted returns. Inflation caused investors to make less money each year than they thought and led to bigger losses when the market was down.
There were even two years (1990 and 2011) when investors thought they made money but actually saw a decrease in wealth.
Inflation causes two problems for investors.
- Inflation makes it difficult to know how much you will actually need throughout retirement. Not only will your money be worth half as much in 30 years but it will half again in another 30 years.
- Since investors don’t account for inflation, low inflation can lead to gambling to reach for higher gains.
This second problem is going to be particularly bad over the next few years at least. With inflation averaging just 1.1% over the last five years, stock market returns of about 5% would actually be the new normal given how much investors have made in the past.
But investors won’t be happy with 5% returns. They’ll hear on TV about those 7% returns of the past and think that’s how much you should make on stocks.
Investors will take more risk trying to reach for those 7% returns and they’ll end up putting more in stocks rather than safer assets. They’ll lose all their money in the next stock market crash and will be no closer to meeting their financial goals.
How to Invest for Inflation
Understanding the first problem caused by inflation risk, the decrease in purchasing power and how much you will truly need in retirement, will help avoid the second problem.
At inflation’s ten-year average, your money is going to half in about 30 years. If you want to keep your same standard of living when you retire, assuming you’re 30 years from retiring, you will need to spend twice as much each year minus the amount you won’t need to buy or save for like saving for retirement or work-related expenses.
The upside is that you might not have to worry quite so much about the effect of inflation on your spending while in retirement. Most retirees spend a little extra immediately following retirement to pursue those leisure dreams but then start to spend less each year as they age.
By the time you reach 75 years old, consumer spending data suggests most retirees are spending about 25% less than they did before retiring. So even as your dollar buys less, you are spending less so it helps to lessen inflation’s bite.
Investing app Personal Capital has some of the best retirement planning calculators to help figure out how much you’ll really need in retirement. It’s free to link up your financial accounts and see where you come out on your financial goals.
Investments for Inflation Risk
Knowing the real cost of inflation and how much you’ll need to spend in retirement will help with constructing your portfolio for the lowest risk you need to meet your goals. Your portfolio will change as you age, something we covered in our investing by age series, but you will always need some investments that help fight the battle against inflation.
Stocks do well against modest and expected inflation. If inflation rises just a few percent or less each year, companies can raise their prices and pass on extra profits to investors…even if those profits are worth less.
In fact, stock returns have beaten inflation 78% of time since 1926 on five-year intervals. That still means a fifth of the time that investors have lost money because of inflation so stocks aren’t the only inflation-fighting investments you need.
Real estate and other ‘real’ assets hold their value against inflation. The easiest way to get real estate exposure is through Real Estate Investment Trusts (REITs) which are companies that invest exclusively in income-producing real estate.
REITs get a special tax break if they return more than 90% of profits to investors. This means not only are REITs good inflation protection but also great for a steady source of income.
I covered more about REITs and other passive income investments in The Passive Income Myth: how to create a stream of income from real estate, blogging, stocks and bonds.
I also like Master Limited Partnerships (MLPs) as ways to invest in real assets and help fight inflation. These partnerships own energy storage and pipeline assets and then provide fee-based services to energy companies. They haven’t been as popular over the last couple of years because of weakness in energy prices but are a good way to own real assets and produce inflation-adjusted returns.
For investment in REITs and MLPs, check out a few of my favorite funds:
- Vanguard REIT ETF (NYSE: VNQ)
- Realty Income (NYSE: O)
- Enterprise Products Partners (NYSE: EPD)
- Enbridge Energy Partners (NYSE: EEP)
Some will include commodities like gold and other precious metals to good inflation-protection investments. I don’t like direct investment in commodities because they don’t produce any income returns and really only gain on market sentiment or changes in inflation. If you are going to invest in commodities, I’d suggest doing it through shares of the miners and other producers to get a share of their constant earnings rather than just an investment in the commodities alone.
The book also suggests Treasury Inflation-Protected Securities (TIPS) which are government bonds that automatically increase along with inflation. The problem with TIPS right now is that it might be a good protection of value but will do almost nothing to grow your money. You’ll earn about half a percent return a year after inflation, which means TIPs should probably not be a big percentage of your portfolio.
Inflation risk doesn’t have to destroy your plans for the future if you understand how to invest to beat it. Understand the difference between reported returns and what you are actually making each year and put some money to investments that will rise along with inflation.