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The Tradeoff: Preserve Capital or Purchasing Power |
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Successful investing and financial planning requires balancing tradeoffs. A common investment tradeoff is "Preservation of Capital" versus "Preservation of Purchasing Power." Preservation of Capital may allow for a better night's sleep during periods of heightened uncertainty but Preservation of Purchasing Power helps ensure you'll have a future bed to sleep in after accounting for rising prices due to inflation. Balancing these two tradeoffs depends on your definition of risk.
Some investors consider risk to be volatility. They have difficulty stomaching the ups and downs in stocks and bonds. The "downs" are usually accompanied with negative headlines that increase the anxiety and fear of loss. These investors long for guarantees that protect their principal. Other investors may define risk as a diminishing standard of living or a loss of purchasing power for their money. These investors recognize that inflation can be a silent killer of a financial plan during retirement. Here are the facts:
The Good News - From 1900-2010, inflation in the U.S, averaged 3.0% while Treasury Bills averaged a riskless rate of return of 3.9% and stocks averaged 9.4%. Both Bills and stocks outperformed inflation with stocks doing so by a substantial margin.
The Bad News - Adjusting these returns for the impact of inflation, the worst period of performance for the stock market was 1929-1931 when on an inflation adjusted basis stocks lost 60% of their value over 4 years. However, it took stocks only 4 years for the subsequent recovery of purchasing power. The worst period of performance for riskless Treasury Bills was from 1933-1951 when on an inflation adjusted basis Bills lost 47% of their purchasing power over a 19 year period. However, it took 48 years for T-Bill investors to recover their purchasing power. The length of the recovery period could be devastating to a retiree on a fixed income.
Worst Inflation Adjusted Performance 1900-2010
The Conclusion
The cumulative effect of inflation over 10 to 20 years of retirement could be more devastating than the volatility associated with the stock and bond market over the same period. At a 3% inflation rate, the purchasing power of a dollar decreases by 25% in 10 years. At 20 years, a dollar is only worth 55 cents of purchasing power. This demonstrates that there is no such thing as a riskless asset. The tradeoff between capital preservation and purchasing power preservation has no right answer. The volatility of stocks and bonds are very apparent as we open our regular statements. Conversely, the risk of investing in CD's, Treasury Bills, and money markets is less obvious and takes more time to detect. This risk shows up when you reach for your wallet to pay for future goods and services. Retirement planning is about finding the right balance of tradeoffs that meet your standard of living requirements. |
