Thursday, October 1, 2009

Inflation Risk and Your Retirement Investments

There are many different risks that must be considered when investing. The risk of loss of capital or default, the risk of the volatility of the asset, and the risk of foreign currency fluctuations are just a few. But one that is often forgotten about is the risk of inflation. Inflation is like a cancer. Even though it seems as if the value of your investment is increasing, your total purchasing power is decreasing.

Net Worth Means Nothing

People like to think of net worth and being a millionaire when they retire. Being a millionaire now means a lot less compared to what it used to mean. One million dollars 1980 is like having between $2 million to $3 million today. One million in 1940 is worth about $15-30 million today. Here is a fun site that you can play around with:

It allows you to compare the value of the dollar from different years in the United States from 1774 to present day. After looking at the difference from 1940 to 2008 compare a similar time period from 1840 to 1908. Look at the change in value of the CPI. There is really not much difference from $1,000,000 to $1,064,439.

The answer to that $64,000 question (pun intended) is that the United States was on a gold standard during the 1800's. The value of the dollar was fairly constant. It was impossible for the government to simply print more and more dollar bills or add some zeroes to a computer entry and create money out of thin air. The paper money that was circulating actually represented gold and silver in a vault. The paper was like a receipt and was redeemable for gold. If the bank didn't have enough gold, then a "run" on the bank occurred, and the banker was out of business.

Purchasing Power

Now, however, the value of the dollar is not constant and can fluctuate relative to many other goods and services. So instead of thinking about how much your investments and savings are worth, you need to think about what they can purchase in terms of food, clothing, shelter, transportation, health care, and travel that you would want to consume during retirement.

Real assets are valuable and tend to keep pace with inflation since people can relate to their value and have a good idea what they are worth. Is a cheeseburger worth $2? You might say yes if you make $8 per hour so that the cost is only 15 minutes of your time. But if $2 was a monthly wage, you wouldn't think so. Would you like to make $10,000 per hour? Of course, unless gasoline cost $100,000 per gallon and that same cheeseburger also cost $100,000.

As you can see, paper currency means little. The values are simply relative and are changing over time due to inflation. Do you really think a gallon of milk will ever cost under $1 again? Unlikely. That is why you want to own investments that will maintain their purchasing power in 30 years when you retire. You want to be able to afford that gallon of milk.

Forget Milk, Got Gold or Silver

I don't have any idea what milk will cost in 30 years when I am retired. I also have no idea what an ounce of gold or silver will cost at that time either. But, I do know that an ounce of silver would be worth about 4 or 5 gallons of milk. I know that I could trade that ounce of gold for about a month's lodging in an apartment. That has certainly been my experience over the past 20 years as I share with you here: Gold, Silver, and Pepperoni Pizza

So, to sum up. Inflation is a cancer which erodes purchasing power. Real assets tend to increase in cost with inflation and will maintain purchasing power. Net worth means nothing. Get exposure to real assets. Next time I will be discussing how to get exposure to real assets.

Until next time--Keep it REAL!

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