Investing Basics: the Risk of Inflation

November 2, 2015

 Last week we began an article series on the different types of risk when it comes to investing for your financial future.  The first risk we discussed, and arguably the most prominent risk for many investors, is the risk of losing money.  This week, we’re going to take the conversation a step further and discuss the risk of not making enough money.

 

Many individuals have a significant fear of their portfolio value going down, but sometimes that fear causes them to make overly conservative decisions that can also be detrimental to their financial health.  While we certainly don’t want to lose money, it’s also important that your portfolio value goes up.  In financial speak, we call this inflationary risk or purchasing power risk.  This is the risk that your nest egg doesn’t keep up with rising prices and it’s actually an incredibly important type of risk to be aware especially if you’re nearing or already in retirement.

 

In 1986, the Economist began tracking the price of a Big Mac in various countries as a way to understand currency strength internationally.  This set of data has since come to be known as the Big Mac Index.  While the purpose of the Big Mac Index is to understand purchasing power from country to country, it inadvertently also allows us to understand purchasing power from year to year.  To understand what I mean, consider that the price of a Big Mac in 1986 was $1.60.  In 2000 the price had risen to $2.51 and today a Big Mac at McDonald's cost $4.79.  The point of this illustration is to show that over time, things cost more.  If you retire in your early 60s and live to your early 90s there are 30 years during which the price of living will slowly increase.  Inflationary risk is the risk that your money doesn’t keep up with the increasing cost of your lifestyle.

 

How then should you respond to this type of risk?  In my mind, there are several key takeaways.  The first is that you should always factor inflation into your financial plan.  It’s not enough to have saved enough to spend $5,000 every month each month for the next 30 years.  You need to save enough to spend $5,000 the first month, $5,010 the second month, $5,020 the third month, $5,030 the fourth month, and so on.  Of course, price increases rarely happen in tiny, smooth increments.  What it really means is that you may need $5,000 a month for the first several years of your retirement until you start to notice that suddenly $5,000 a month isn’t quite making ends meet and so you begin needing $5,500 a month.  Either way, the point is that your need is highly unlikely to be static because the cost of living is not static.  The second takeaway is that while you shouldn’t invest beyond your ability to handle risk, you also shouldn’t slide to the other end of the extreme and leave all of your money in cash and t-bills.  The only way to keep up with inflation is to invest in something that keeps up with inflation and if inflation is around 2%, but your CD is only making 1% - you’re not keeping up.

 

If you’d like to learn more about the best way to invest for rising prices or would like a complimentary financial plan, feel free to give us a call.  We’re happy to help.

 

 

“The Big Mac Index.” The Economist. July 16, 2015. http://www.economist.com/content/big-mac-index.

 

“Big Mac Index: The United States.” Find the Data. 2015. Graphiq, Inc. http://big-mac-index.findthedata.com/l/1/United-States-2012.

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