Why is managing inflation risk important?
All investments are associated with Risk. Even the safest investments such as the U.S. Treasury securities issued by the US Department of Treasury and Certificate of Deposits (CDs) issued by FDIC-insured banks or credit unions are associated with risk, Inflation Risk.
What is Inflation?
Inflation indicates a decrease in the purchasing power of a dollar. In general, as the price of the things you buy goes up overtime, you can buy less with each dollar. Hence, you will need more money to keep the same standard of living in future years due to inflation. For example, $1.00 in January 2000 has the same buying power as $1.53 in March 2020 per The Bureau of Labor Statistics’ CPI Inflation Calculator. That is a loss of more than 50% in purchasing power over 20 years!
Inflation in this blog references price inflation. Monetary inflation is another type of inflation due to an increase in money supply which could lead to price inflation.
The inflation rate is measured by the annual change in the consumer price index (CPI). The Bureau of Labor Statistics (BLS) publishes consumer price index (CPI). The following table from 2017 lists the goods and services that make up the CPI. The table also indicates the percentage of disposable income (after tax) spent on each category. Based on CPI table, housing is the largest driver of inflation followed by transportation, food and beverages, medical care, and apparel.
What is core inflation?
The core CPI excludes food and energy as it is too volatile as evident in the CPI graph below. The percentage change in CPI for all items excluding food and energy is in the range of 1% to 3%, while the percentage change in CPI for all items including food and energy is in the range of -2% to 6%. This volatility in food and energy may be one of the reasons federal policy makers exclude food and energy from CPI to make decisions about monetary policy.
The Federal Open Market Committee (FOMC), the Federal Reserve’s body, judges that an annual increase in inflation of 2% as most consistent with price stability. Therefore, FOMC adopted an inflation target of 2% in 2012.
Managing Inflation Risk
In order to maintain the purchasing power of your investment, you want to make sure that your investment grows above the rate of inflation. Let’s compare two investment vehicles, equity and US Treasury Bond, and see how they hold up against inflation! The table below indicates growth of $1,000 initial investment over 30 years in the two investment vehicles.
| Investment Vehicles | Initial Investment | Rate of Return* | Final Value of Investment |
|---|---|---|---|
| US Treasury 30 Years Bond | 1,000 | 1.47% | 1,549 |
| Equity (S&P 500) | 1,000 | 6.8% | 7,197 |
*The annualized return not adjusted for inflation for S&P 500 from 2001 to 2019 including dividends is 6.8% (4.7% adjusted for inflation), well above the inflation rate. The current 30 year treasury yield is 1.47% (as of May 2020).
Assuming an average inflation rate of 3%, 30 years from now, $1,549 (Treasury investment final value) would be equivalent to $638, well below the initial $1,000 dollar investment.
In comparison, $7,197 (equity investment final value), with an average inflation rate of 3%, would be equivalent to $2,965, well above the initial $1,000 dollar investment.
Although loss of principal is not likely with the US Treasury 30-Years Bond, it will lose its REAL purchasing power due to inflation.
Therefore, you will have to invest a portion of your investment in equities to at least maintain the purchasing power of your investment. However, equity investments such as stocks, mutual funds and ETFs are not without risk. Unlike inflation risk, stocks, mutual funds, and ETFs are associated with the “market” risk. In addition, equity investment is volatile and there is no guarantee of return of principal amount.
Although past performance is not a guarantee of future results, the historical data from 1900 to 2020 shows that, with all of the booms and busts of the equity market, the annualized real return (adjusted for inflation) of S&P 500 (including dividend reinvestment) is 6.5% (well above average inflation rate of 2% to 3%).
Therefore, you should consider investing a portion of your savings in “risky” investments such as stocks, mutual funds, and ETFs to manage inflation risk.
How are you managing inflation risk with your portfolio?