A couple of weeks ago we shared a chart illustrating how prices on goods have changed in the last 30 years due to inflation. Today, we’d like to share another way inflation can affect us—on our investment returns.
Very few of us have enough money today to pay for everything we will need in the future, especially when prices of goods and services rise by an average of 3% per year. Given that fact, we must invest our money with the goal of combatting that erosion of purchasing power that occurs over time.
The question then becomes — what to invest in? The chart above illustrates the return on several different asset classes.
Cash has had a long-term return of 3.5%, which doesn’t sound too bad until you realize that you’ve basically only kept pace with inflation and have not actually gained any wealth in real terms. In many cases, such as today’s low interest environment, leaving money in checking, savings, money market funds or short term CDs can often lead to negative real returns, as inflation is currently running higher than the payout on many cash-like investments.
Next we see that Bonds earned a higher return of 5.5%, but even that return loses more than half of its value when inflation is factored in. Once you consider that many investors withdraw 3, 4 or 5% a year from an account, an asset class returning 2.5% after inflation will quickly erode.
That leaves us with Stocks. Investing in companies has returned 6.7% even after factoring in inflation, as most firms are able to adjust prices to adapt to rising inflation, something a fixed bond payment cannot do. Imagine a gas station adjusting its prices in seconds as fuel prices rise, or McDonalds charging more for a Big Mac in 5 years than it would today. We know stocks can be extremely volatile in the short term; however, the average retirement period these days can easily last 30 years. The ability for companies to be able to change prices to adjust for inflation mean it’s likely a necessary component for a well-diversified portfolio to be able to last an entire retirement and beyond.
Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price.
Stock investing involves risks, including increased volatility (up and down movement in the value of your assets) and loss of principal.
Investors with time horizons of less than five years should consider minimizing or avoiding investing in common stocks.