Investing timidly may shield you against risk… but not against inflation.
Provided by Frederick Saide, Ph.D.
When is being risk-averse too risky for the sake of your retirement? After you conclude your career or sell your company, you have a right to be financially cautious. At the same time, you can risk being a little too cautious – some retirees invest so timidly that their portfolios barely yield any return.
For years, financial institutions pitched CDs, money market funds and interest checking accounts as risk-devoid places to put your dollars. That made sense before the Federal Reserve took interest rates down to historic lows. As the benchmark interest rate is now negligible, these conservative options offer you minimal potential to grow your money.
In 2014, annualized inflation has vacillated between 1.1% and 2.1%. Yields on typical 1-year CDs, money market funds and interest checking accounts haven’t even kept up with that.1,3,4
The rise of the all-items Consumer Price Index doesn’t tell the whole story of inflation. Food and electricity prices rose 3.1% during the 12 months ending in October, for example.2
With the federal funds rate still at 0%-0.25%, a “high-yielding” 6-month CD might return 0.75% for you, and the yield on a 1-year CD might barely be above 1%. Looking at Bankrate’s survey of CD rates as 2014 draws to a close, that’s exactly what we see. A good yield on a 5-year CD is less than 2.5% right now. (Some history worth noting: on average, those who put money in long-term CDs at the end of 2007 the start of the Great Recession saw the income off those CDs dwindle by two-thirds by the end of 2011.)3,4
Retirees shouldn’t give up on growth investing. Many people in their fifties, sixties and seventies need to accumulate more wealth for retirement – even with their current or imminent need to withdraw their retirement savings. Because of that reality, many baby boomers and seniors can’t refrain from growth investing. They need their portfolios to yield at least 3% and preferably more. Otherwise, they risk losing purchasing power as consumer prices increase faster than their retirement incomes.
Do you really want to live on yesterday’s money? Could you imagine trying to live today on the income you earned back in 2003 or 1998? You wouldn’t dare try, right? Well, this is essentially the dilemma that risk-averse retirees face. They realize that their CDs and money market accounts are yielding almost nothing; they are withdrawing more than they are earning and their retirement fund is shrinking. So, they must live on less.
In recent U.S. history, inflation has averaged 1.7%-4%. What if that holds true for the next 20 years?5
For the sake of argument, let’s say that consumer prices rise 4% annually for the next 20 years. That doesn’t sound so bad – you can probably live with that. Or can you?
Given 4% inflation across 20 years, today’s dollar will be worth 44 cents in 2035. Today’s $1,000 king-sized bed will cost about $2,200 in 2035, and today’s $23,000 coupe will run more than $50,000.5
Beyond prices for durable goods, think of the cost of health care. Think of the income taxes you pay. When you add those factors into the mix, growth investing looks absolutely essential. There is certainly a role for fixed income investments in a diversified portfolio – you just don’t want to tilt your portfolio wholly away from risk.
Accepting some risk may lead to greater reward. As many equities can potentially achieve greater returns than fixed income investments, they may prove less vulnerable to inflation. This is especially worth remembering given the history of the CPI.
From 1900-1970, inflation averaged about 2.5% in America. Starting in 1970, the annualized inflation rate started trending higher and by 1979 it was at 13.3%; the 1970s saw consumer prices rise 102.91%. While we have only seen about 2%-3% yearly inflation since 1990, U.S. consumer prices still rose more than 80% from 1990-2012. So a coat you could have bought for $100 in 1990 would have cost you more than $180 in 2012.5,6
All this should tell you one thing: you can’t hide in fixed income. Even mild inflation has a powerful cumulative effect, so you might as well invest to keep pace with it or outpace it.
Frederick Saidemay be reached at 908-791-3831 ext. 102 or email@example.com or
This material was prepared by a third party, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 – investing.com/economic-calendar/ [12/4/14]
2 – bls.gov/news.release/cpi.nr0.htm [11/20/14]
3 – bankrate.com/cd.aspx [12/4/14]
4 – newsday.com/lifestyle/retirement/alternatives-in-a-low-interest-world-1.3615707 [3/24/12]
5 – us.axa.com/retirement/inflation-and-long-term-investing.html [2/2014]
6 – inflationdata.com/Inflation/Inflation/DecadeInflation.asp [4/15/13]