You’ve probably come across an old restaurant menu in an antique store or a curio shop (or if you’ve ever eaten in a Cracker Barrel restaurant). Perhaps you’ve seen reproductions of a page out of a newspaper from the 1930s or some other past period. It’s interesting to notice what common items used to cost: a cup of coffee for a nickel, pork roast for 15 cents per pound, a gallon of gas for a quarter (I actually know a guy who remembers that last one).
It’s pretty amazing to realize how much prices, in general, have increased over time. If you’re of “a certain age,” think about the first house you ever bought. At the time, you probably swallowed hard, thinking about the prospect of actually paying back “all that money” you borrowed for your mortgage. But now, that same amount of money might represent no more than a single year of mortgage payments. One of my friends, who is a few years older than me, told me that the annual salary for his first job out of college, back in 1977, was $11,600 — and he couldn’t imagine how he would ever spend all that money!
Times — and Prices — Have Changed
Over time, changes in price have gone in a single direction: up. This phenomenon, of course, is called “inflation,” and it affects just about every facet of life. Inflation especially impacts saving and investing, and the unfortunate fact is that it is the one financial risk that is impossible to escape.
Why? Well, economists can offer many reasons, but the broad-brush answer is that as the world’s population continues to increase, more consumers are competing for available goods and services. It’s simple supply and demand: When more and more people want the same things, the cost of acquiring those things has to go up. If you live in the world, you’re going to experience inflation.
The problem for savers and investors is that, when you are saving money for a purpose a number of years in the future — like retirement or college tuition for young children — inflation causes the purchasing power of today’s dollars to decrease over time. The longer the time, the worse the effects of inflation.
What Can You Do to Hedge Against Inflation?
Many investors have realized that since the risk of inflation, especially over longer periods of time, is close to 100%, they must consider investments that have a chance of growing faster than the rate of inflation. For example, the average rate of inflation in the United States since 1926 has been 2.94%. During that same period, the stocks making up the S&P 500 Index increased in value by more than 500%, after inflation was factored in. In other words, a dollar invested in the S&P 500 at the beginning of the period would be worth more than $500 today. At the same time, a dollar invested in U.S. Treasury bills — perhaps the investment with the least risk of default — would be worth about $1.51 today, after allowing for inflation.
Does this mean that every long-term investor should always buy stocks? No, because there are other, well-known risks associated with investing in stocks, including their much higher volatility. However, as we can also see from history, keeping all your money parked in lower-volatility, low-default-risk investments like U.S. Treasury bills would not allow for much of an increase in purchasing power over the long term.
For many investors, the answer may lie in the same fundamentals that we preach, over and over, to our clients: strategic planning, diversification, rebalancing, and ongoing risk assessment. Since inflation is the one risk we absolutely cannot eliminate from the portfolio, we typically advise a balanced approach that utilizes a variety of holdings with diversified risk characteristics. This allows us to offset risks while maintaining a portfolio that fits the individual investor’s long-term strategy.
In other words, since we cannot completely eliminate risk, we use an approach that manages it in order to give the investor the best long-term chance of preserving both the integrity of the portfolio and its purchasing power.
Stay Diversified, Stay Your Course!