February 27th, 2012 | Forbes
Fighting Inflation with your Portfolio
In recent weeks I have discussed ways to weave tax planning into your investment strategy. Taxes will take a bite out of investment returns, but at least you have some control over how much tax you pay. The same cannot be said of inflation, a scourge that is the largest single enemy of long-term investors. This week and next I will provide some thoughts on handling this perennial challenge to investors.
Taxing your Wealth
One interesting way to think about inflation is as a wealth tax that is levied on your fortune every year. With income taxes, you owe the government money only if you earn taxable earned or unearned income such as capital gains and interest in a given year. With a wealth tax, such as a property tax, you’re on the hook for payments every year whether your asset increases in value, declines or stays the same. Therefore, growing and preserving purchasing power of capital in order to meet future needs becomes one of the great challenges of long-term investing.
A few numbers help illustrate the challenge of simply keeping pace with the steady increase in the cost of living. Most of you know what you pay today for a loaf of bread, a movie ticket and a gallon of gasoline. Exactly 50 years ago, in 1962, bread cost 20 cents, a movie ticket 50 cents and a gallon of gas 31 cents (Source: Baby Boomer Headquarters website). Imagine being in retirement and living on a fixed income that is not adjusted for inflation such as this. Budgeting for one set of costs and being confronted with monthly expenses that have escalated would create quite a problem.
From January 1, 1926 through December 31, 2011, the US consumer price index (CPI) rose 2.99% annualized (Source: Ibbotson). Interestingly, in 2011 CPI inflation was also 3% (US Department of Labor), with groceries up 6% and gasoline rising 10%. Now 3% inflation may sound relatively tame to you, but over long time horizons it produces meaningful declines in purchasing power due to compounding. For instance, what costs $100,000 today costs $243,000 after 30 years of 3% inflation. Or, from another angle, a silent wealth tax of 3% reduces $100,000 of invested money to only $40,000 after 30 years of 3% inflation.
Sizing up Inflation
I am not going to make any bold predictions about the inflation level in the years ahead. What is fascinating, however, is the dichotomy of debate on this topic, with reasonable people predicting both deflation and higher inflation. The deflationists tend to point to recession in Europe, elevated unemployment and excess capacity in the US, the deflationary impact of debt deleveraging, weak aggregate demand, and so forth. Those in the inflation camp point to easy money policies in the US and now Europe and Japan, the ultimate effect of large budget deficits in the developed world, and robust demand for food, oil, metals and other raw materials in China and other growing developing economies.
My advice is to not get sucked into the crystal ball-gazing game, but to focus on building inflation protection into your portfolio. We have no control over whether Iran attempts to close the Straits of Hormuz, another devastating earthquake cripples industrial capacity in Japan, or Mother Nature spoils the corn and soybean harvest in the Midwest. But we can construct portfolios aimed at protecting purchasing power. Indeed, it is my observation that many investors ignore the portfolio scourge of inflation, which has a way of sneaking up on us. And when they do focus on inflation, such as after an unexpected spike in prices, it is probably too late.
Inflation presents a special challenge for all investors, and one that is quiet and often underestimated. Long-term investors must focus on preserving purchasing power. Next week I will return with some perspectives on stocks, bonds and other asset classes in the context of building inflation protection into your portfolio.
As Published On: Forbes
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