Part 2: Understanding Inflation – choosing the right investments during inflation

Overview
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. In last week’s article, I provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. This week I want to show the importance of investing in assets that grow faster over time than the rate of inflation. Sophisticated investors know they must increase the value of their portfolio at a higher rate than inflation in order to grow their wealth. Any growth rate lower than inflation (such as the interest rate paid on most savings accounts) would still erode the value of the investment portfolio over time. Lets look closer at this balance of growth against inflation.

Overcoming the effect of inflation
As stated above, there are two opposite forces that affect what your long term investment portfolio will end up accumulating: inflation and rate of growth. Any long term investment strategy must consider the effect of both and incorporate a plan for accumulating assets that will increase in value faster than the rate of inflation. To do this, many investors seek assets that have limited quantity such as rare high grade coins, rare art, gold, desirable real estate. Over time, the scarcity of the asset will make them harder to buy so the price usually goes up. In addition, accredited investors have access to other investments that have high risk of loss, but demand high rates of return such as participation in a private placement, special hedge/leveraged funds, providing seed capital for a new or young business/product/service, etc. These investments each carry different levels of risk and expected returns. All of these factors need to be incorporated into a long term investment strategy/plan.

You must have an investment strategy/plan
An investment strategy must have set investing rules and boundaries you will maintain no matter what. Consistently applying a strategy over time will take out emotional decisions that usually go against what needs to be done during times of uncertainty. Your strategy should incorporate your end goal, how long you plan to invest, and what you are going to invest in to get there. You can make improvements in your plan, but only change one thing at a time - don’t make another change until enough time has past to confirm if the change worked or should be reversed. Continuing this refinement process will go a long way toward getting you to your end goal and help refine your investing skills.

Research historical returns on your prospective investment
Keep in mind a general estimate of inflation is about 3% to 4% per year. You want to make sure your entire portfolio gets at least 4% over time just to keep up the same real overall value. Ideally, your return should consistently be higher than the historical rate of inflation to increase your buying power by the time you retire. Maximizing contributions into tax free accounts is one of the best ways to increase compounding of your long term investments by deferring taxes on the gains.

We are currently in a very scary down market. Seems like everything has dropped considerably including “blue chip” stocks, real estate, minerals such as oil and gas, etc. However, if this down turn is like so many others in the past, then these assets will again come into favor with increasing prices along historical averages. Research the historical average of assets you want to learn about investing in. Within those assets, learn what makes some more desirable than others (for example, different locations of real estate have dramatically different historical returns). Chose those assets that provide the historical returns you need to reach your goal as part of your strategy. Diversify enough to decrease the risk of loss to your portfolio, but not too much as to dilute any gains made by each asset. Periodically shift funds from one asset to another to rebalance your portfolio.

Putting it together
In a previous article on compounding interest, I showed how a $1,000 investment in a tax free compounding interest account after 40 years can provide an additional 122% return at 4% interest rate ($2,224 account total minus the $1,000 invested, then divide that difference of $1,224 by $1,000 to get 122%), 394% at 8% ($4,940 balance - $1,000, then divide by $1,000), and 5,759% at 16% ($576,923 balance - $1,000, then divide by $1,000).

In last week’s article, I showed how inflation does the opposite by reducing the buying power of $1,000 over 40 years to only $201 for a consistent 4% rate of inflation. This is a 80% reduction ($1,000 - $201, then divide by $1,000) in buying power. In other words, $201 is only 20% of the value the initial $1,000 after 40 years. In reverse, to maintain a $1,000 buying power after 40 years you would have needed to initially invest $5,000 the first year ($5,000 x 20% after 40 years leaves $1,000). Starting with five times the initial $1,000 investment defeats the purpose of keeping that initial $1,000 investment at the same buying power after 40 years. Therefore, we need to invest the $1,000 at a compounding rate that negates the devaluing rate from inflation. Since we need the initial $1,000 invested to act like $5,0000, we must invest at an annual rate that generates 400% return after 40 years ($5,000 - $1,000 invested means we need to generate the equivalent of $4,000 additional dollars in the beginning over the 40 years or 400%). From the previous paragraph, we need an annual tax free compounding interest rate of 8%. Interestingly enough, this is the historical growth rate you hear that the stock market has grown. That is why many financial advisors recommend investing in a stock index (S&P 5000) to keep up with inflation. Of course, these days that seems like bad advice with the significant drop stocks have taken in only a few months. But, if you believe history will repeat itself again, then you should still include stocks in your investment strategy to assure gains keep up with inflation. As mentioned earlier, there are many other investments that historically have met or beat the historical rate of inflation such as choice real estate, private placements,

Summary
A small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. Your investment strategy/plan must include investing in assets that increase with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.

Next article in this series
Next week's article covers the relationship between the price of gold and value of the dollar during times of inflation and deflation.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors. This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content