The Impact of Inflation
When the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved.
This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk.
We can alternatively look at the effects inflation has had on common goals many Americans share including buying a home, obtaining a higher education, and purchasing a car. In 1970, the median cost of a new home was $23,600. That same home in 2017 now costs $315,200, representing an increase of over 1,000%. The same is true for obtaining a higher education and purchasing a car.
After the Great Recession, many investors became risk averse and understandably so. The natural response for many Americans who suffered major portfolio declines was to move their retirement savings away from stocks and take shelter in investment and bank products like bonds, annuities, CDs, or even savings accounts. While investors may have sheltered themselves from the volatility of the markets, they introduced their lifetime savings to inflation risk. This risk is only compounded when you consider the low yields of bonds and savings accounts today and the fact that Americans are living longer than ever before. How can investors potentially prevent this loss of purchasing power from inflation over time?
INVESTING FOR THE LONG TERM
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.
While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth. This is especially true when you consider that many retirees today could live well into their 90s.
Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. At River Capital Advisors, we help our clients understand how inflation can erode the purchasing power of their savings and build a portfolio to help achieve their goals and objectives. If you are not currently a client of River Capital Advisors and would like to learn more about our services, please contact us.