by FPA member David Zuckerman, CFP®, CIMA®
Last Updated: May 20, 2013
Do you take inflation into account when making financial decisions? If you do then you’re much better equipped to make financial decisions than investors who routinely ignore the impact of inflation. Inflation measures the rise in prices for goods and services over time; and without accounting for its effects, you could be falling victim to the money illusion.
As Warren Buffet has stated, “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital.”
The Effects of Rising and Falling Prices
Inflation can act as a tax because rising prices erode purchasing power over time. The best way to counteract, or hedge against, inflation is to invest your money. Keeping money in a bank savings account or money market fund simply won’t generate enough return for your money to keep pace with rising price levels.
Inflation in the U.S. has generally been incremental and gradual. While there have been periods, most recently in the 1970s, when inflation suddenly spiked, inflation in the U.S. has averaged about 3% over long periods of time.
Although it is usually inflation that drives investments, deflation, or falling prices for goods and services, can bring another set of challenges. Deflation is much less common than inflation, but it can persist over long periods of time, as it has in Japan since the early 1990s.
When prices are falling the dollars you have today will be worth more in the future, which can lead to a deflationary spiral whereby consumers and companies horde cash instead of spending and investing, thereby reducing aggregate demand. The self perpetuating cycle of falling prices and reduced demand can be very hard to stop. While the Great Depression is a classic example of a deflationary spiral, periods of deflation have generally been far less frequent and much shorter than periods of inflation, which is a fundamental macroeconomic trend.
Accounting for Inflation & Deflation
Consider the following scenario that was presented to a group of participants in a psychology experiment:
Peter, Paul, and Mary each bought a home for $200,000 and sold it one year later. When Peter owned his home the overall economy experienced a period of 25 percent deflation, and the home was sold for $154,000, or 23 percent less than he paid. The situation was reversed for Paul, with the economy experiencing 25 percent inflation while he owned his home, which was sold for $246,000, or 23 percent more than he paid. While Mary owned her home the overall cost of goods and services remained the same, and the home was sold for $196,000, or 2 percent less than she paid.
Eldar Shafir, a professor of psychology at Princeton, presented this scenario to participants in an experiment and asked them to pick the investor that fared the best. About 60% of the participants thought Paul fared the best with a 23 percent gain when prices rose 25 percent. The reality, however, is that both Paul and Mary experienced a 2 percent loss of purchasing power. Peter, on the other hand, fared the best because he was able to increase his purchasing power by 2 percent. Under Peter’s scenario, seventy-five cents could purchase a dollar’s worth of goods and services last year but Peter was able to obtain seventy-seven cents for each dollar he invested in his home.
Real vs. Nominal Price Changes
As Shafir was able to demonstrate with his experiment, investors are prone to confusing nominal price changes with real changes in purchasing power.1 This phenomenon, the money illusion, can lead investors to invest too conservatively by failing to account for the detrimental effects of inflation.
Consider an individual with $20,000 to invest. Investing in the stock market would grow that sum to over $93,000 over a 20 year period if stock market returns average 8 percent per year. Investing the sum in bonds instead of stocks, assuming an average annual return of 4 percent for bonds, would equate to only about $43,800 over the same period of time. On the surface, turning a $20,000 investment into $43,800 may seem like an acceptable outcome, but once inflation is accounted for the results look very different. Inflation that averages 3 percent per year means that $20,000 earning a 4 percent return would only grow at a 1% rate and only equal about $24,400 in real terms (current purchasing power) over 20 years.
The individual that keeps money in a bank accounts, CDs, or money market funds that yield 1 percent during 3 percent inflation is even worse off. While the idea of holding cash may be emotionally appealing in order to avoid market volatility, the reality is that this individual would have only about $13,300 in today’s purchasing power at the end of the 20 year period. Investing that same $20,000 in stocks that average an 8 percent annual return with 3 percent inflation would result in about $53,000 of current purchasing power. In this example, investing in stocks equates to quadruple the purchasing power of holding cash in bank accounts, CDs, and money market funds.2
Think of Inflation as a Tax
One of the best ways to help yourself quantify the effects of inflation on your money is to think of inflation as a tax. Like Warren Buffet said,
“It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income taxes during years of 5 percent inflation. Either way, she is 'taxed' in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax but doesn't seem to notice that 6 percent inflation is the economic equivalent.”
If you need help balancing the risk of the stock market with the risk of inflation, consider finding a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association® to help you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1 Gary Belsky & Thomas Gilovich, Why Smart People Make Big Money Mistakes and How to Correct Them (Simon & Schuster, 1999), 105 – 111
2 Note that the calculations are performed using a simple approximation for inflation adjusted returns where inflation adjusted return = rate of return – inflation rate. The actual formula for inflation adjusted returns is inflation adjusted return = (1+ return)/(1+inflation rate) – 1.