|
It should come as no surprise to any consumer that the prices of products have steadily increased over time. For example, a gallon of gasoline cost a mere $.33 in 1967, a gallon of milk cost only $1.03 per gallon in that same year, a first class postage stamp would have cost only $.05. When compared to today’s prices, the costs of these items have risen by approximately 600%, 190%, and 680% respectively.
The culprit behind the ever increasing costs of the things we purchase is a word known by almost everyone – inflation. But just what is inflation and how should it shape the strategies of investors?
Inflated Costs
Inflation is defined by economic textbooks as the “rate at which the general level of prices for goods and services is rising.” What this means in practical terms is that, except for rare periods of time when the costs of goods and services actually decline (called deflation), the cost of the things we buy tends to increase over time.
For investors, inflation’s impact is measured by calculating the real rate of return for an investment, which is defined as the rate of return earned after accounting for inflation. For example, your savings account is earning 3% annually but inflation is averaging 2% per year, your real rate of return (the actual net increase of your money’s purchasing power) is reduced to only 1%.
So, investors must seek returns which will consistently outpace inflation or risk a continued decline in the amount of goods and services which can be purchased. The best investment to fight inflation, however, will vary with the unique situation of each investor.
Time is on Your Side
For long-term investors, the most effective investment for overcoming inflation has been the stock market. Historically, inflation has averaged approximately 3% per year. Investments in large company domestic stocks, however, have historically averaged approximately 10% annually, easily overcoming the impact of inflation.
However, as has been experienced recently, the stock market can be extremely volatile over shorter time periods and may not be the preferred vehicle for overcoming inflation for all investors. Fixed income investments would seem to be the most obvious alternative to equities, but these securities also have limitations in effectively combating inflation.
So Predictable
Certificates of deposit, bonds and other fixed income investments do just what the name implies – pay investors a set amount of income over a defined time period. This type of investment is also very predictable, as investors who hold fixed income securities to maturity know the exact return which will be received (represented by the interest payments and a return of the original investment.)
The challenge with utilizing fixed income investments as an inflation hedge lies with the historical real rates of fixed income returns. For example, the interest rate on a 10-year U.S. Treasury bond currently stands at 4.63%. If inflation should average even close to the historical annual average of 3% over the next ten years, an investor who holds a 10-year U.S. Treasury bond will realize a real annual return of only 1.63%. While 1.63% represents a positive rate of return, it would seem that most investors would not be completely satisfied with this outcome.
Obviously, the predictability of fixed income investments is attractive, but the long term performance of these investments versus inflation leaves something to be desired. An alternative investment, however, offers the advantages of fixed income investments with the benefits of inflation protection.
Investment TIPS
Treasury Inflation Protected Securities (TIPS) provide investors with the advantages of fixed income investments and protection against inflation. The principal value of a TIPS bond increases and decreases with the rise and fall of inflation, as measured by the Consumer Price Index Urban (CPI-U). TIPS are issued in maturities of 5, 10, and 20 years and at maturity the investor is paid the greater of the inflation adjusted principal or the original principal.
The actual interest paid by TIPS bonds is applied semi-annually at a fixed rate, and the interest rate is applied to the current value of the inflation adjusted principal. Thus, the interest payments rise or fall as the principal is adjusted for inflation.
Unfortunately, TIPS are not guaranteed to be the best investment option over time. The current yield on a 10-year TIPS bond is 2.27%. With the 10-year Treasury bond yielding 4.63%, inflation would have to average in excess of 2.36% annually for the TIPS bond to be a superior ten year investment. While average annual inflation of 2.36% would be below the 3.0% historical average, a TIPS investor has the potential to experience returns which do not exceed that of a normal fixed income investment if higher inflation does not materialize.
Numerous other investments are also available to investors seeking to overcome inflation. Real estate, commodities, gold and a host of other investments have at times provided returns which beat inflation. However, for the majority of investors, a properly diversified portfolio which includes a combination of equities, traditional fixed income, and TIPS securities should provide the opportunity to earn investment returns which will overcome the impact of inflation.
Source: Ibbotson, U.S. Census Bureau, Investopedia.com
|
