There are many issues that we face in retirement. We are going to focus on the effects of inflation.
When it comes to your retirement portfolio and the effects of inflation, let’s begin by considering what you want to accomplish as an investor. Why do people invest at all? People have different financial needs and goals, and therefore, they may invest for different reasons. One major reason is to grow their wealth — for example, in preparation for retirement. Whatever their reason for accumulating money, there’s another concern that creates the need to invest: the threat of inflation.
Inflation erodes the real purchasing power of your wealth. (Fig.A)
Consider an illustration of the effects of inflation over time. In 1913, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And 100 years later, nine cents would only buy about six tablespoons of milk. So, as the value of a dollar declines over time, you invest to grow wealth and preserve purchasing power.
We often hear people say, “yes, but investing is risky.” But considering the long-term threat of inflation, not investing means taking risks, too. If you don’t grow your money, you may not be able to afford things in the future.
So, how do people invest to grow their wealth? (Fig.B)
Most look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation.
This is documented in the growth of wealth graph, which shows monthly performance of various indices and inflation since 1926. These indices represent different areas of the financial markets, such as stocks and bonds.
Keep in mind that there’s risk and uncertainty in the markets and that historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.
Fig.A Milk Comparison: In US dollars. Source for 1913 and 1963: Historical Statistics of the United States: Colonial Times to 1970/U.S. Dept. of Commerce. Source for 2013: United States Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index–Average Price Data.
Fig.B Index: Past performance is no guarantee of future results. In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. See “Growth of Wealth Indices” page in the Appendix for more information. US Small Cap Index is the CRSP 6−10 Index; US Large Cap Index is the S&P 500 Index; Long-Term Government Bonds Index is 20-year US government bonds; Treasury Bills are One-Month US Treasury bills; Inflation is the Consumer Price Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Bonds, T-bills, and inflation data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).