AN INFLATIONARY TALE: "HOW DOES INFLATION AFFECT MY INVESTMENT?"

Inflation is a complicated concept.  It’s simply not easy to understand but if you choose to ignore it, your money will slowly and stealthily go from your pocket to someone else’s.  Thus the subtitle of this tale is How Does Inflation Affect My Investment.  As a teenager growing up in the 70’s I would hear the newscasters talk about inflation and price controls yet could never tell if it was a good or bad thing.  Interest rates were going up as were house prices and income.

This had to be a good thing I thought but little did I know.  What I learned later in life as I studied inflation is that like most things, inflation is a double-edged sword.  There are winners and there are losers.  It is good for some and bad for others.  As you read this tale focus on the two main concepts about inflation.  Learn what it is and what it means to an investment portfolio.  In A Preservation Tale, I will walk you through some ways that in the past worked to protect your capital from inflation.   Hopefully you will learn a logical framework so that you can possibly be positioned on the “gain” side of the equation instead of the “pain” side.

WHAT IS INFLATION?

So what is inflation?  Type the word inflation into your favorite search engine and you will probably get directed to Wikipedia.  There, you will read that inflation is “A rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects an erosion of purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.  A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.”  If you are like me and read the above definition you are thinking blah, blah, blah, blah, blah.  So since the objective of Financial Tales is to keep things simple, let’s just translate this to what it means to an investor.

I like to think of inflation in terms of what can $100 buy in the future if I don’t invest it today.  If I make 0% rate of return on my $100 bill because I take it and put it under my mattress or bury it in the ground or keep it in a safety deposit box and a few years later I want to know what it can buy this is what inflation means to the investor or consumer.  What that $100 can buy is called purchasing power and purchasing power is directly proportional to the rate of inflation.  The following table shows what $100 un-invested can buy at different inflation rates over different time periods.  I call it my Mattress Investing table because it teaches us you can’t put money under your mattress unless you want to guarantee that you will slowly erode the value of your money.

MATTRESS INVESTING

(The Loss of Purchasing Power Associated with Not Investing $100.00)

How should an investor read this table?  Investors should understand that if they keep their money in a mattress for 15 years and the inflation rate over the 15 year period is 5% per year their $100 can only buy $46.33 worth of “Stuff.”  If inflation were to average 7% for 30 years their $100 could only buy $11.34 worth of “Stuff.”    I know it’s silly to think that anyone would keep their money in a mattress but the reason I use the table above is because it illustrates the important concept about inflation which is loss of purchasing power.  Inflation in and of itself is meaningless.  What matters to people is what inflation causes which is the loss of purchasing power.  As an example, when I get in my car to drive I have a rudimentary notion of how the engine functions.  People that know me know I’m not mechanically inclined.  I do however know how the steering wheel works.  To an investor, inflation is the engine while purchasing power is the steering wheel.  You can be completely oblivious to how an engine works and still be an excellent driver.  So if you are so inclined you can spend a disproportionate amount of time studying how the engine works or the nuances of inflation or you can learn how to drive and invest your money to combat the loss of purchasing power.  How to invest your money to combat inflation is discussed in A Preservation Tale.  I’ll give you a little hint—I am not a Gold Bug but if you put a $100 gold coin under your mattress instead of a $100 bill you have a much better chance of preserving purchasing power during inflationary times.

READING THE MATTRESS INVESTING TABLE

So once again, how should an investor read the Mattress Investing table?  Let’s focus on the 3% inflation rate since that has been a good approximation for so many decades.  What this table shows is that if the inflation rate is 3% and you keep your $100 under your mattress, in 5 years it will only buy $85.87 worth of “Stuff.”  I like to use the technical term “Stuff” to describe purchasing power.  To investors, the intended use of a $100 bill is to be able to buy “Stuff.”  In and of itself the $100 bill is worthless.  Its only value is the amount of “Stuff” it can buy.  In this case it can only buy $85.87 worth of “Stuff” so the Mattress Investor has lost $14.13 of “Stuff” by keeping it in his mattress or not investing it.  When you hear the term Loss of Purchasing Power it means “Stuff” you can’t buy.  This leads directly to what I consider the minimum objective for investors and one of my maxims.  The purpose of investing should be to at a minimum maintain your purchasing power.  I believe you should invest so that you don’t lose your “Stuff.”

So let’s put our knowledge to the test.  If the inflation rate is 3% over the 5 years how much money would you have to make to breakeven or maintain your purchasing power?  This is where things get tricky.  At first glance you might answer that you need to make $14.13 to maintain your purchasing power.  But you would be wrong.  While you would have $114.13 at the end of 5 years it could only buy you $98.00 worth of “Stuff.”  The best way to think about this problem is to divide your $114.13 into two pieces, the original $100 and what you’ve earned over the 5 year period or $14.13.  When you do this you quickly learn that the $100 has lost 14.13% of its value and can only buy $85.87 worth of “Stuff” and the $14.13 has also lost 14.13% of its value and can only buy $12.13 of “Stuff.”  When you add $85.87 and $12.13 you get $98 so your $114.13 can only buy $98.00 of “Stuff.”

Let’s test our knowledge further.  At what rate of return over the 5 years period would you have to invest your $100 in order to have it still buy $100 worth of “Stuff” or maintain its purchasing power?  If you answered 3% you would be wrong.  At 3% you would have $115.93.  If you break it into two pieces like I suggest your original $100 is worth $85.87 and your $15.93 is worth $13.68.  Together this is only $99.55.  The correct answer is you would need to have $116.46 in order to maintain purchasing power.  For the math inclined, the $116.46 can be calculated by dividing 1 by .008587 and this translates to a compounded annual growth rate of 3.09%.    So please commit the following to memory since it’s all you ever need to know about inflation–You need to make a higher rate of return on your investments than the inflation rate in order to maintain purchasing power.

I would bet if you interviewed 100 investment advisors that only a handful would have this knowledge.  The majority would say if the inflation rate is 3% you need to make a 3% return in order to maintain purchasing power.  They would be wrong but so what, they’re sticking to it.  You however don’t have the luxury of misunderstanding this concept.  Always remember-it’s your money and you are responsible for it.  If you read A Purchasing Power Tale, which I recommend be read right after this tale, I provide a table that shows the rates of return an investor needs to make in order to preserve purchasing power.

WHAT CAN WE LEARN?

So what can we learn from this tale that puts money in our pocket?  Who wins and who losses from inflation?  By now it should be clear that at any inflation rate greater than 0% you must make more than 0% on your money in order to maintain purchasing power.  Yet when guaranteed interest rates are not accommodative, like they are today and have often been in the past, the investor must invest in non-guaranteed investments to maintain purchasing power.  For investors that have read tales such as this one this presents a quandary.  They can intelligently ask themselves, if I want a guarantee and guaranteed rates are so low that I can’t preserve purchasing power then I must accept a loss of purchasing power.  However, if I want an opportunity to maintain purchasing power I must assume risk.  This is the never-ending portfolio management question that is forever on every investor’s mind and will be at every stage of their life.  While most investors answer this question by forgoing guaranteed returns in order to not just maintain purchasing power but to potentially increase purchasing power, others do not.  There are investors that choose to avoid risk at all cost and are knowingly watching their purchasing power erode slowly in some guaranteed interest environments.  Unfortunately, the sad circumstance for most risk-averse investors is they behave as they do out of ignorance or fear and not based on knowledge.  Many are willing to invest their money in bank CDs, money market funds and government bonds at below required levels just to keep it guaranteed.  The only guarantee they’re getting during most periods is the guarantee of a loss in purchasing power.  When and if there is increased inflation these are the people that will also suffer the most.

Who benefits then when we experience an increase in the inflation rate?  The answer is simple.  Those that own “Stuff” benefit and those that owe on “Stuff” at a fixed interest rate benefit even more.  Many are familiar with Shakespeare’s quote “Neither a borrower nor a lender be.”  Whenever I hear this piece of advice all I can think is that The Bard of Avon had never experienced inflation.  If he had he might have written, though surely more elegantly–you should be a borrower and not a lender during inflationary times.  So what can we expect and what should we do with our money to win the preservation of purchasing power game?  To find out some techniques that work or at least have worked, I suggest you read A Preservation Tale.  If you must provide income from your investments you should read A Distributive Tale or else you might run the risk of running out of money prematurely.

Lastly, I have included a paragraph from a 1977 article written by Warren Buffett for Fortune Magazine on inflation.  Inflation was a big deal back then though we tend to dismiss it today since it’s been so low for so long.  But I thought the paragraph would be appropriate since it is easy to understand writing and he has a unique way of thinking about inflation as a tax.  If you think of it the same way you will quickly understand that inflation is a consumer of your capital.  We as a society take to the streets if there is so much as a hint of our elected officials raising our taxes.  Yet we have no problem when we willingly or out of ignorance tax ourselves by investing in below inflation rate guaranteed investments.  The following is taken straight from the article.

WHAT WIDOWS DON’T NOTICE

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn’t seem to notice that 6 percent inflation is the economic equivalent.