It should be clear from Lesson 1-3 that inflation is an enemy of the investor because it erodes the value of money. While inflation has been low the past decade, it can always return.
Inflation is the biggest threat to someone in retirement that depends solely on the income generated from their investments. This is because a retired person can’t easily re-enter the work force and inflation can dilute their wealth’s purchasing power. It is vital that the investment income generated from a portfolio provides a return at least equal to the rate of inflation. And ideally an investor wants to see their real purchasing power increase and therefore would like to earn investment returns in excess of the inflation rate by at least two or three percent.
To ensure that an individual’s income from their investments keeps pace with inflation, there are two important principles:
- The first is that the underlying investments should generate a continuous income that over time outperforms the inflation rate. On this basis, as well as that of historical yields on asset classes, a yield of at least two or three percentage points above the inflation rate is acceptable. This would be close to the historical total return on bonds.
- For risky assets (common stock, real estate, etc.), the total return (capital appreciation and dividend yield) should be about five to seven percent more than the inflation rate, because such investments carry more risk than bonds.
If the future inflation rate is estimated to be 3% on average for the next 5 years, this means that bonds need to deliver a total return of 5-6% over the period (3% for inflation plus an acceptable return of 2-3%). On the same assumption an investment in common stock should produce a total return of 8-10% (inflation plus 5-7%).
Currently, long-term U.S. Government bonds are only yielding a rate that is about equivalent to the expected rate of future inflation (about 2.5 – 3%) – so investors need to maintain well-diversified portfolios that include common stocks. To avoid experiencing a loss of purchasing power, investors need to have a healthy mix of stocks, bonds and other investments in their portfolio.
Another option to protect purchasing power and investment returns over the long-term is to add inflation-protected securities, such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These bonds tend to move with inflation and therefore offer long-term immunity to inflation risk. In summary, investing only in savings accounts and money market instruments will not likely generate enough of a return to offset inflation – and individuals need to include risky assets within their investment portfolios.