Anyone who has paid for gasoline, health care or college tuition lately knows that even if the overall rate of inflation is modest, there are areas where costs are rising more dramatically. Earning returns that exceed the cost of living is important for all investors, but it is especially critical for those who may depend on their portfolios as a source of income.
What Is Inflation?
Inflation is the increase in the price of any good or service. The most commonly referenced measure of that increase is the Consumer Price Index (CPI), which is based on a monthly survey by the U.S. Bureau of Labor Statistics. The CPI compares current and past prices of a sample “market basket” of goods from a variety of categories including housing, food and transportation.
Inflation has been a consistent fact of life for U.S. consumers. Between 1900 and 1970, inflation was moderate, averaging 2.5% annually. From 1970 to 1990, however, the average rate increased to around 6%, hitting a high of 13.3% in 1979.1 Recently, rates have been closer to the 2% to 4% range, averaging 3.2% in 2006.
What It Means to Your Finances
An inflation rate of 4% might not seem significant until you consider the long-term effect on your purchases and your investments. For example, in 20 years, 4% inflation annually would drive the value of a dollar down to $0.44.
The Cost of the Future2
||Price in 2006
||Price in 2026
Inflation also works against your investments. When pursuing long-term financial goals, from college savings for your loved ones to your own retirement, it’s important to consider the real rate of return, which is determined by figuring in the effects of inflation.
Investing to Beat Inflation
A Balancing Act Over the long run — 10 years or more — stocks may provide the best potential for returns that exceed inflation. While past performance is no guarantee of future results, stocks have historically provided higher returns than other asset classes. A Standard & Poor’s analysis of holding periods between 1926 and 2006 found that the annual return for a portfolio comprised exclusively of stocks in the S&P 500 was 10.49% — well above the average inflation rate of 3.04% for the same period.3 The average annual return for long-term government bonds, on the other hand, was only 4.86%.
Keep in mind that stocks do involve greater risk of short-term fluctuations than other types of investments. Unlike a bond, which guarantees a fixed return if you hold it until maturity, a stock can rise or fall in value based on daily events in the stock market, trends in the economy or problems at the issuing company. But if you have a long investment time frame, you may find that stocks offer the best chance to beat inflation.
The key is to consider your time frame, your income needs and how much volatility you are willing to accept, and then construct a portfolio with a mix of stocks and other investments. For instance, if you have 30 or 40 years until you plan to retire, a portfolio weighted to stocks or stock funds might be suitable. But even if you are approaching retirement, you may still need to maintain some growth-oriented investments as a hedge against inflation. Your retirement assets may need to last for 30 years or more, and inflation will continue to work against you throughout.
There are many ways to include stocks in your long-term plan in whatever proportion you decide is appropriate. You and your financial advisor could create a diversified portfolio of shares from companies you select. Another option is a stock mutual fund, which offers the benefit of professional management. Stock mutual funds have demonstrated the same long-term growth potential as individual stocks. S&P tracked domestic equity mutual funds from 1987 through 2006 and found an average annual return of 11.8%.4
Whether you’re a first-time investor or an experienced retiree, you need to keep inflation in your sights. Stocks may be your best weapon, and there are many ways to include them. Your financial advisor can help you determine your best options.
1Source: U.S. Bureau of Labor Statistics.
2Based on an average annual inflation rate of 4%.
3Source: Standard & Poor’s. Performance is for the period December 31, 1926, to December 31, 2006. Stocks are represented by the total return of the S&P 500 Index, bonds by long-term Treasuries (10+ years). Past performance cannot guarantee future results. Individuals cannot invest directly in any index. Results include reinvested dividends.
4Source: Standard & Poor’s. Based on average annual returns of all U.S. equity funds, including sector and balanced funds. Does not reflect sales charges or other expenses associated with purchasing mutual fund shares. Past performance is no guarantee of future results.
Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus.
Bonds are subject to market and interest rate risk of sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
Copyright © 2007 MWBoone and Associates, LLC All Rights Reserved. MWBoone and Associates is a Registered Investment Advisor. Further disclosures at www.mwboone.com. Securities offered through Linsco/Private Ledger Member FINRA/SIPC.