By: Frank Armstrong, III, CFP®, AIFA®
As this is written in December of 2008, the global stock markets are headed for one of their worst years ever. Not the worst, but pretty bad. The equity investment results for the year are so discouraging that you might be forgiven for wondering, “What am I doing here?”
The answer is simple. There is no option, not at least if you want to hedge inflation and have any real return. You simply can’t do that with fixed income or guaranteed investments. A quick look at long term returns will disclose that guaranteed investments track inflation closely, and on an after tax basis, are net losers.
Simply put, the “safe” investment alternatives provide no real return (inflation adjusted), while stocks have outpaced inflation (real growth) by about 8%. We have really good data back to 1926, before the depression and stock market crash, through today to back this up. The long term trend is gratifyingly positive.
Despite the disappointing market performance this year, the argument for appropriate equity exposure in your portfolio is as strong as ever. Equity exposure means market risk, and that in turn means that some years market values decline. An 8% risk premium is a handsome return for putting up with the market fluctuations.
You know without being told that the overall trend of consumer prices is up. Inflation is a fact of life and it’s not going to go away. Most people assume that the official rate grossly underestimates their real life experience. Over time, if left unchecked, the loss of buying power is enormous. For instance, in my distant youth a nickel bought a candy bar big enough to trigger a diabetic coma, a coke, or a telephone call. That nickel won’t buy much today.
Failing to even match inflation is no small thing. If you plan to live more than a year, and/or if you want to pass on your hard earned wealth to the next generation, you simply can’t afford a negative real return. You can’t even afford a zero real return. Here’s why:
- Let’s say that you have 30 years to save for retirement. The goal is to have enough saved up so that after retirement you can draw down your nest egg at your current income level for exactly 30 years and then it’s gone. We are going to assume that you are unwilling to take any risk over what’s necessary to match the inflation rate. Additionally, to keep the problem simple, we are going to assume that you never get another raise. To meet this goal you will have to contribute 50% of your pretax income each year. Given that you must pay taxes and live in the meantime, that’s not realistic for most of us.
- Here is another example: You retire today with a lump sum and draw down only “safe” investment returns for income from your portfolio. Assuming a very modest 3% inflation rate (it’s 5% today), your sustainable withdrawal rate is 3%. Because of inflation, your real income will be cut by 26% in ten years, 46% in 20 years, and 60% in 30 years. So, it takes $1.34 in ten years, $1.81 in 20 years, and $2.43 in 30 years to buy what your dollar will purchase today.
It follows that for us to meet any realistic investment goal we must invest for a positive real rate of return. Like it or not, we must assume some risk in our investments. The trick is to manage risk toward some optimal result, take no more risk than you can afford, take no more risk than you can stand emotionally, and then stay the course. It’s not a sexy approach, and sometimes, like today, it calls for discipline, but it’s the only time tested way to harvest what the market offers.
Preparing financially means that money your portfolio is expected to generate for the next several years is set aside in rock solid fixed income instruments like Money Market Funds, CD’s and Short Term High Quality Bond Funds. This will provide the liquidity to ride out the inevitable financial storms.
Preparing emotionally means to determine your risk tolerance before the inevitable market downturns. One of the surest ways to destroy wealth is to sell after the market is down. So determine your asset allocation based on a reasonable worst case scenario that you can tolerate, and then consider yourself committed to endure the ups and downs of the market.
We must accept measured amounts of market risk, not because we like it, but because it’s the only way to achieve our financial objectives. This practice is painless while the markets are going up, but requires discipline during the inevitable market declines. Managing the risks, taking the right amount of risk, providing for liquidity needs and maintaining a long term outlook are the essential components of a successful investment experience.