Inflation Investing: the Money Illusion

My own investment policy consists of holding index funds and looking for large moves in the market to have appropriate asset allocation.  I generally leave the stock picking to others and try to be contrarian to broad market emotions as much as possible.  Interestingly, I think we are at a major turning point when broad asset allocations make sense.  In particular, as the news fills with doom and gloom about the current recession, my bet is that the long-term successful investors (like Warren Buffet) see the next big cyclical turn as being the threat of global inflation.  And by this, I mean not inflation as in 3-4%, but I mean a change in cycle to having structurally higher inflation for a number of years.  I previously wrote about investing during inflation and looked at some of the types of investmets that should hold up well during an inflation cycle, particularly commodity-related investments and TIPS (inflation-indexed treasuries).  The topic seems of interest to a lot of people, so I thought more detailed analysis was warranted.

One of the major questions in peoples minds, has to be, what is the harm in a bit of inflation.  After all, when prices are constantly rising, people feel more motivated to put their capital to good use.  In addition, having pay raises usually makes people feel better.  But, this is the problem, especially in the United States.  While nominal wages have (mostly) risen, real wages have not kept up with inflation for many workers.  This is the problem called the money illusion.  In other words, because your paychecks are growing larger over time, you think that you think of this as a raise or cost of living increase.  In fact, if the cost of living outpaces your raises, you have in effect gotten poorer, or your salary has lost real value.

To illustrate this from a saving standpoint.  Let’s say you have $100,000 in savings today, but you want to hold off spending until retirement.  If you decide to put your savings under a mattress (meaning you earned zero interest or dividends), in 25 years time, at a 3% inflation rate, your $100k would be the equivalent of about $48k in the future.  But let’s say inflation crept up to 5% a year, a rate that was not unusual a decade ago. Under this scenario, your $100k should be thought of as less than $30k in 25 years time.  And, if we end up with double digit inflation at 10%, the 100k adjusted for buying power in today’s dollars looks like a measly $9230.

Not many people are expecting a shift to a very high inflation rate, like 10%.  However, a lot of people have pensions, annuities, or other fixed payments that are not adjusted to inflation.  For those investments, it is important to consider the declining purchasing power that your savings will have over time.  The recent stock market declines appear to have made a number of people more cautious.  Unfortunately, this means that a number of investors who become conservative due to the downturn are at risk of seeing inflation eat away at the purchasing power of their savings.  Next week, I’ll examine investments that have historically kept up with inflation.

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