Long-term investing: remember inflation

A penny saved is a penny earned, right? Not necessarily. Thanks to inflation, over time that penny could be worth less than when it was first dropped into the piggy bank. That's why if you're investing – especially for major goals years away, such as retirement – you can't afford to ignore the corrosive effect rising prices can have on the value of your assets.

Watch for a rising Consumer Price Index

Just what is inflation, this ravenous beast that eats away at the value of every dollar you earn? It is essentially the increase in the price of any goods or services. The most commonly referenced measure of that increase is the Consumer Price Index (CPI), which is based on a monthly survey by the U.S. Bureau of Labor Statistics. The CPI compares current and past prices of a sample "market basket" of goods from a variety of categories including housing, food, transportation, and apparel.

The CPI does have shortcomings, according to economists – it does not take taxes into account or consider that as the price of one product rises, consumers may react by purchasing a cheaper substitute (name brand vs. generic, for example). Nonetheless, it is widely considered a useful way to measure prices over time.

Inflation has been a very consistent fact of life in the U.S. economy. Dating back to 1945, the purchasing power of the dollar has declined in value every year but two – 1949 and 1954. Still, inflation rates were generally considered moderate until the 1970s. The average annual rate from 1926 to 1970 was approximately 1.9%. From 1970 to 1990, however, the average rate increased to around 6%, hitting a high of 13.3% in 1979.* Recently, rates have been closer to the 1% to 3% range; the inflation rate was 2.11% in 2017.

*Source: U.S. Bureau of Labor Statistics.

Inflation can erode your investments

In today's economy, it's easy to overlook inflation when preparing for your financial future. An inflation rate of 4% might not seem to be worth a second thought – until you consider its effect on the purchasing power of your money over the long term.

In just 20 years, 4% inflation annually would drive the value of a dollar down to $0.44. If the price of a $1,000 refrigerator rises by 4% over 20 years, it will more than double to $2,200, given the same inflation rate and time period. Under the same conditions, the price of an automobile that costs $23,000 today would soar to more than $50,000.

Inflation also works against your investments. When you calculate the return on an investment, you'll need to consider not just the interest rate you receive but also the real rate of return, which is determined by figuring in the effects of inflation. Your financial professional can help you calculate your real rate of return.

Clearly, if you plan to achieve long-term financial goals, such as college savings for your children or your own retirement, you'll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation.

Over time, stocks can outpace inflation

Protecting your portfolio against the potential threat of inflation might begin with a review of the investments most likely to provide returns that outpace inflation.

Over the long run – 10, 20, 30 years, or more – stocks may provide the best potential for returns that exceed inflation. While past performance is no guarantee of future results, stocks have historically provided higher returns than other asset classes.

Consider these findings from a study of Standard & Poor's data, keeping in mind that it is not possible to invest directly in an index.

An analysis of holding periods between 1926 and December 31, 2017, found that the annualized return for a portfolio composed exclusively of stocks in the S&P 500 index was 10.22% – well above the average inflation rate of 2.89% for the same period.  The annualized return for long–term government bonds, on the other hand, was only 5.63%.**

Diversification as an inflation fighter

There are many ways to include stocks in your long-term plan in whatever proportion you decide is appropriate. Your financial professional can help you develop a diversified portfolio of shares from companies you select.

Another option is a stock mutual fund, which offers the benefit of professional management. Stock mutual funds have demonstrated similar long-term growth potential as individual stocks. You might also consider IRAs and variable annuities, which allow you to select from a variety of investment portfolios, including growth-oriented portfolios. As you approach retirement, you can shift assets to a more conservative portfolio if appropriate.

Total annual returns for stocks, bonds, and inflation

This chart tracks inflation versus the annual returns of the S&P 500 and long-term government bonds.** Large-Cap stocks are represented by the total annual returns of the S&P 500. Investment-grade bonds are represented by a composite of the total annual returns of long-term Treasuries (10+ year maturities), the Barclays Long-Term Government Bond index, and the Barclays U.S. Aggregate index. Inflation is represented by the annual change in the Consumer Price Index. Past performance is not indicative of future results.

**Source: ChartSource^®, DST Systems, Inc. For the period from January 1, 1988, through December 31, 2017. Stocks are represented by the S&P 500 index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond index. Inflation is represented by the change in the Consumer Price Index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Past performance is not a guarantee of future results. © 2018, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. (CS000169)

Your time horizon also affects your asset allocation

Keep in mind that stocks do involve greater risk of short-term fluctuations than other asset classes. Unlike a bond, which guarantees a fixed return if you hold it until maturity, a stock can rise or fall in value based on daily events in the stock market, trends in the economy, or problems at the issuing company. The key is to consider your time frame, your anticipated income needs, any other savings and assets you might have, and how much volatility you are willing to accept, and then construct a portfolio with the mix of stocks and other investments with which you are comfortable.

Take steps to tame inflation's bite

Whatever your investor profile – from first-time investor to experienced retiree – you need to keep inflation in your sights. Stocks may be your best weapon, and there are many ways to include them. Consult your financial professional to discuss your specific needs and options.