How to Balance Capital Preservation and the Effects of Inflation
When it comes to managing wealth for the long term, some investors choose a strategy of capital preservation. For these investors, on an emotional level, it might seem easier and more prudent to hang onto the wealth they’ve already accumulated, rather than putting it at risk to potentially earn a higher return.
This makes sense intuitively, and yet a capital preservation strategy that doesn’t take inflation into account could effectively lose money over time. That’s because inflation erodes the buying power of each dollar you have, year after year.
Therefore, to truly preserve the value of your capital, it’s useful to maintain an awareness and understanding of inflation.
How inflation erodes value
The “inflation rate” describes the way prices increase from one year to the next. It’s measured by checking the prices of numerous commonly-used goods and services, which are aggregated and indexed in the Consumer Price Index (CPI). The rate of change of the CPI represents the inflation rate.
While inflation can be high, low, or even negative, the US has typically experienced slow and steady inflation over time — the kind that you don’t really notice on a day-to-day basis. The long-term average inflation rate in the US is 3.28% per year. 1
This relatively steady inflation rate is the reason that stuffing cash under the mattress isn’t a good idea. At the long-term average, you’d need about twice as much income in 20 years as you do today in order to enjoy the same lifestyle. In other words, while a $20 bill is always a $20 bill, the purchasing power of that $20 is likely to decrease over time. Just think about how much it cost you to see a movie as a kid, or how much money you spent filling the tank of your first car.
Because of that erosion in purchasing power, a capital preservation strategy should be designed to take inflation into account.
A new understanding of capital preservation
One way to build inflation into your wealth planning is to focus on maintaining a given lifestyle rather than a given asset base. In other words, adjust your strategy towards keeping your purchasing power stable, rather than keeping a certain dollar amount of money.
This subtle distinction can help you incorporate inflation into your overall wealth management strategy. For example, when reviewing your budget it can be useful to think about how the inflation rate has changed and how much more income you’ll need in a year to keep your lifestyle the same. For example, at 1% inflation, a $50,000 budget today would need to grow by $500 next year to maintain the same level of purchasing power.
At the same time, when looking at annual investment performance, review the numbers with inflation in mind. You can subtract the inflation rate from your investment returns to get to what’s called the real rate of return. This number excludes the portion of your returns that was “lost” to inflation, making it a more accurate way of gauging your returns in terms of what you can buy. For example, if your portfolio returned 5% last year with inflation at 1%, the real rate of return — the increase to your purchasing power — was actually 4%.
By sizing up your income needs and your investment performance in this way, you can develop a new understanding of how your portfolio is doing relative to your long-term needs and goals.
Designing an inflation-aware portfolio
There are a number of ways to balance growth and risk within a capital preserving investment strategy. The key is to balance these risks in a way that makes sense for your investment goals, personal risk profile, and time horizon.
In doing this assessment, it’s important to remember that any investment strategy involves risk, and the risks vary depending on the asset class. For example, one type of investment could have high potential returns that far outpace inflation in some years but which are highly volatile, while another could have low and steady returns that run the risk of falling behind the inflation rate. Finding the right mix of asset classes requires a holistic view of what your investment assets need to accomplish for you.
That’s why, in the end, the asset allocation you choose for your portfolio should be designed with your unique financial situation and goals in mind. Otherwise, you could end up taking on too much risk in one place or another. To strike the right balance, it can help to speak to an advisor.
Keep an eye on it!
Right now, keeping a close eye on inflation might seem like an unnecessary investment of time and effort. With the CPI growing at just under 1% since last year, most consumers are experiencing very small incremental changes to the value of their money.
But inflation compounds, just like interest — and it isn’t consistent. While we’ve had low inflation recently, things can always change, and even at low rates the erosion of value can become significant over time. Getting into the habit of thinking about inflation and planning accordingly will help you to make more thoughtful lifestyle choices, investment plans, and even retirement goals.
Think of it like flossing: an almost laughably small effort that can pay dividends over time.