The Real and Present Danger of Inflation, Even for Babies

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Investors greatly under estimate the danger of inflation. The markets are inherently volatile, but at least on average they go up and they probably will continue to go up indefinitely. Inflation causes any cash or cash-based investment instruments to go down. Cash, bonds, and fixed annuities are all, on average, hurt by inflation.

There is a very popular piece of financial software that has tried to model the volatility of stock investments. This company includes in its Monte-Carlo simulation a small chance of a black-swan event that devastates stock investments. As a result, projections for a 100 years that include stock investments have a very real chance of failing. When you try to model the optimum asset allocation and withdrawal rates for a newborn baby with a trust fund, the program suggests that a mostly bond allocation would be better than a mostly stock allocation.

Yet that advice is completely wrong.

A newborn baby with a trust fund should have a mostly stock allocation. The trust fund has to keep up with inflation for 100 years.

The correct asset allocation for a newborn might be 18% in stable investments such as bonds to cover the next six years of spending and 82% in stocks to grow the portfolio for the 94 years after that.

I called the company and was able to talk with the developers and programmers about the inconsistency between common sense and the advice of the software. From that conversation I learned about the small chance of a stock market black swan event that they had programmed into the software. I asked them if they had programmed in any chance of an inflation black swan event. They said “No, you input an average inflation amount, and we use that amount as a straight line projection every year for 100 years.”

The mistaken method of modeling inflation resulted in a mistaken analysis that under estimates the devastating effects of inflation.

For investors who began working in 1970 and retired 45 years later in 2015, cash lost 83.83% of its purchasing power. You might think that including the 1970s when we experienced a larger than normal inflation skews this result, and you would be partly correct. But there is also a chance that we will experience a greater inflation than we currently have. Or there is even a chance that we will experience a hyper-inflation even greater than we did in the 1970s.

The official CPI-U index has been relatively low for the past decade. The official measure for the 12 months ending in December of each year starting in 2008 has been 0.09%, 2.72%, 1.50%, 2.96%, 1.74%, 1.50%, 0.76%, 0.73%, 2.07%, and 2.11%. The latest value for inflation is 2.87% as of June, 2018.

At a rate of 2.87% inflation will devalue the currency by 72.01% over the next 45 years.

Here is a table of various inflation rates and value that would be lost to inflation over 45 years.

Inflation Value lost over 45 years
0.00% 0.00%
1.00% 36.09%
2.00% 58.98%
2.87% 72.01%
3.00% 73.56%
4.00% 82.88%
5.00% 88.87%
6.00% 92.73%
7.00% 95.24%
8.00% 96.87%
9.00% 97.93%
10.00% 98.63%

 

Your long term investments need to appreciate well over inflation. The best method to do that is to stay mostly invested in stocks.

Photo by Michal Bar Haim on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)