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Macro Minute: Week of November 27, 2023

Readers who missed the first installment in my inflation series can find it here. In this piece, I want to move from what inflation is and why it is, to what it means from a saving and investment perspective.

To start, let’s choose a method of measurement for inflation. I am going to use the Consumer Price Index (CPI). Any measure of inflation is inherently controversial because everyone spends money on different things. The CPI is a basket of about 80,000 different prices from about 23,000 different retailers and is tracked and reported monthly. I have a chart hanging on my wall that has data going back to 1926 and ending in 2022. In that 97-year period, inflation has averaged 2.9%. That is how much in the average year your dollar has decreased purchasing power. Put another way, a dollar today was worth about 50 cents 24 years ago. Half of the value of your dollar is lost to inflation about every 24 years.

To take this one step further on identifying the problem, let’s look at a few scenarios. Let’s assume that a typical saver worked and was able to save $10,000 a year for the last 30 years. Let’s also assume that they are risk averse and only put the savings into a savings account paying the same rate as the 90-day treasury bill. Over the last 30 years, inflation averaged 2.51% and the 90-day T-bill has averaged 2.28%. This would let the saver accumulate $423,761.72 dollars, but it would actually have lost $15,755.20 dollars in purchasing power. This is just for illustrative purposes because sequencing of returns and inflation would have some effect on the outcome, but we are beginning to uncover how pervasive the problem is. This is why some people call inflation a hidden tax. It silently takes away your savings without you noticing.

What can we do to overcome this pernicious problem?

From our example above, we can see that just putting our money in savings isn’t enough to overcome inflation. What we can do is invest our savings in other assets that come with higher historical returns. Large Cap U.S. stocks over the same 97-year period has returned 10.1% annually. The issue that arises when taking long term returns as assumptions is that they mask the sequencing of the returns. That 10.1% does not happen in a predictable way. It is lumpy and prone to down years. Investing in these higher volatility assets does fix the inflation problem but introduces new problems with inconsistent return streams.

The best way to overcome this is to invest in a diversified portfolio of different return streams to help give both the returns needed to overcome inflation and smooth out those lumpy returns. On the same chart hanging on my wall, it has the returns of a diversified portfolio. It consists of 50% US Large Cap, 10% US Small Cap, 30% Bonds, and 10% cash. This relatively simple portfolio produced 8.7% returns over that 97-year period. It did this with much less volatility compared to the US Large Cap alone, 13 vs 19.8.

Life is all about tradeoffs. We need to be able to stimulate the economy at times. Because of that, we create inflation. Because inflation exists, we cannot simply save our money to get ahead. The best way to overcome this loss of purchasing power is to invest in a diversified basket of securities. This does create more volatility than savings alone but is the only way to overcome the ravages of inflation.


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