HOW TO DEAL WITH HIGH INFLATION: A PURCHASING POWER TALE

01 Sep HOW TO DEAL WITH HIGH INFLATION: A PURCHASING POWER TALE

Ideally, this tale should be read after An Inflationary Tale since combined the two explain concepts essential to every investor regardless of sophistication or investment objective.  In An Inflationary Tale we learned basic concepts about the cost of not investing money, the types of investors that benefit or are harmed from inflation and some basic principles about purchasing power and the relationship it has with the inflation rate.  We also learned the purpose of investing should be to at a minimum maintain your purchasing power.  This tale focuses on the relationship between the rate of inflation and the rate of return an investor needs to maintain their purchasing power.  What I want investors to take away from this tale is simple and reinforces what we learned before; you need to make a higher rate of return on your investments than the inflation rate in order to maintain purchasing power.  It doesn’t need to be much higher but it must be higher.  If you don’t understand this hire an advisor.  If your advisor doesn’t understand this, find another advisor.

Let’s resurrect the table we used in terms of dealing with high inflation during An Inflationary Tale in case you didn’t get a chance to read it.  In the table we see there are consequences to not investing your money and the higher the rate of inflation the more purchasing power you lose.  Let’s focus on the 3% inflation rate for right now to understand the relationship between inflation rate and the preservation of purchasing power and let’s make it into a typical exchange or discussion you might have with your advisor.

Mattress Investing

(The Loss of Purchasing Power Associated with Not Investing $100.00)

Inflation Rate 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years
0% $100.00 $100.00 $100.00 $100.00 $100.00 $100.00
1% $95.10 $90.44 $86.01 $81.79 $77.78 $73.97
2% $90.39 $81.71 $73.86 $66.76 $60.35 $54.55
3% $85.87 $73.74 $63.33 $54.38 $46.70 $40.10
4% $81.54 $66.48 $54.21 $44.20 $36.04 $29.39
5% $77.38 $59.87 $46.33 $35.85 $27.74 $21.46
6% $73.39 $53.86 $39.53 $29.01 $21.29 $15.63
7% $69.57 $48.40 $33.67 $23.42 $16.30 $11.34
8% $65.91 $43.44 $28.63 $18.87 $12.44 $8.20
9% $62.40 $38.94 $24.30 $15.16 $9.46 $5.91

You walk into the advisor’s office and they show you the above table.  They point to the 3% column and show you that if inflation is 3% this year that an un-invested dollar will only buy $97 dollars worth of “Stuff” next year.  You look at it and naturally conclude like the advisor wants you to conclude that you need to match the rate of inflation or make $3 or 3% in order to maintain your purchasing power at the end of the year.  If you believe this you are wrong.  You need to make 3.09% to maintain your purchasing power.  To understand why let’s look at the next table.

The following Table shows what your money needs to grow to in order for you to maintain your purchasing power.

Maintaining Purchasing Power

(What $100 Must Grow to Over Time and at Different Inflation Rates in Order to Maintain Purchasing Power)

Inflation Rate 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years
0% $100.00 $100.00 $100.00 $100.00 $100.00 $100.00
1% $105.15 $110.57 $116.27 $122.26 $128.56 $135.19
2% $110.63 $122.39 $135.40 $149.79 $165.71 $183.32
3% $116.45 $135.61 $157.92 $183.89 $214.14 $249.37
4% $122.64 $150.41 $184.47 $226.24 $277.47 $340.30
5% $129.24 $167.02 $215.85 $278.95 $360.50 $465.90
6% $136.26 $185.66 $252.98 $344.70 $469.68 $639.98
7% $143.74 $206.62 $297.00 $426.91 $613.66 $882.09
8% $151.73 $230.21 $349.29 $529.96 $804.09 $1,220.02

If these numbers look daunting they aren’t.  If you read A Compounding Tale you will learn the power of compound interest.  It can be your best friend.  The best way to understand this table is to look at this one and the one above it and pick similar years and inflation rates.  For example, to maintain your purchasing power your $100 today must be able to buy $100 worth of “Stuff” at any future point in time regardless of the inflation rate.  So if you look at 3% inflation and 5 years of time you get the number $116.45.  You then look at the other table and see that the $100 is only worth $85.87.   If you then multiply $116.45 by .8587 you arrive at $100.  If you do this for any similar pair of inflation rate and time you always arrive at the $100.

This brings us to the final table to understand the relationship between the inflation rate and purchasing power.

Required Rate of Return

(The Rate of Return Required in Order to Maintain Purchasing Power)

Inflation Rate5 Years10 Years15 Years20 Years25 Years30 Years
0%0.00%0.00%0.00%0.00%0.00%0.00%
1%1.01%1.01%1.01%1.01%1.01%1.01%
2%2.04%2.04%2.04%2.04%2.04%2.04%
3%3.09%3.09%3.09%3.09%3.09%3.09%
4%4.17%4.17%4.17%4.17%4.17%4.17%
5%5.26%5.26%5.26%5.26%5.26%5.26%
6%6.38%6.38%6.38%6.38%6.38%6.38%
7%7.53%7.53%7.53%7.53%7.53%7.53%
8%8.70%8.70%8.70%8.70%8.70%8.70%
9%9.89%9.89%9.89%9.89%9.89%9.89%
10%11.11%11.11%11.11%11.11%11.11%11.11%

If you don’t understand the need to preserve purchasing power with your investment portfolio you must do it in other ways that don’t include classic portfolio management.  These ways are as old as time and need to be pointed out repeatedly because it’s a decision every investor must make.  Remember that a portfolio that maintains or exceeds purchasing power can consist of just 1 asset.  You can buy something that has an intrinsic value, hold on to it and if all goes well it might be worth more in the future than you paid for it or at least on par with inflation.  Those that bought gold for example in the year 2000 are very happy today 11 years later.  You could instead invest your money to build or create something that also has an intrinsic value and eventually sell it for more than it cost you or at least on par with inflation.  This applies to those that start businesses.  As we all know the objective of Wall Street is to convince you to give your money to someone you don’t know for something you can’t touch that will be invested based on some theory and which may or may not be worth anything or millions in the future.

However, that is not your only option as we learned in A Tale of Diversification.  Never forget that a portfolio can have many different manifestations and does not have to be a Wall Street version of a “Diversified portfolio with the proper asset allocation and rebalancing.”  It is your money and if you choose to directly manage a concentrated, no stock, no bond portfolio, you can succeed.As we can see from this table, you must earn slightly more on your money than the inflation rate in order to maintain purchasing power.  Many college textbooks have decided to purposely let the student assume the inflation rate is the investment hurdle rate required to maintain purchasing power but we see it isn’t.  For the math inclined you can read about the Fisher Equation to gain added insight.  This rule of thumb assumption has come about I suspect because at low levels of inflation like the ones we’ve experienced for the last almost 30 years it seems like a good approximation.  However, the relationship between real interest rates that let you buy as much “Stuff” as before and nominal interest rates that delude you into thinking you can buy more “Stuff” needs to be understood.

In summary, you must make a higher rate of return on your investments to maintain your purchasing power and at a minimum your goal as an investor should be to maintain your purchasing power.

Carlos Sera
carlos@seracapital.com

Carlos Sera Founder of Sera Capital Management, LLC Co-Founder of Chicago Wealth Management, Inc. Registered Investment Advisor Speaker on Financial/Investment Planning Fluent in Spanish – First Generation Cuban/American Author of Financial Tales Blog Education Johns Hopkins University – BA – Natural Science – 1980 University of Rochester – MBA – Finance and Applied Economics – Honors – 1982 Find me on:  LinkedIn | Twitter

Share Your Tale

Are you ready to share your Financial Tale?

One of the benefits our financial tales community enjoys is the ability to submit their own tale. We will keep your name private of course and if you send us a detailed overview of your financial situation we will respond to you directly in private and if your tale might be interesting to others we will share it with our fans and community.