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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. The first article provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. Last week’s article discussed the importance of investing in assets that grow faster over time than the rate of inflation. This article will discuss the relationship between the value of the dollar and prices of high demand commodities such as gold during times of inflation.
Valuing the dollar
Normally the dollar is worth more or worth less based on the demand for U.S. goods, services, and assets/products. If foreign investors buy lots U.S. items such as real estate, treasury bonds, stocks, or other, then they must first convert their currency into dollars in order to pay for the purchase. When there are many foreign investors converting to dollars, then the demand for dollars is high and the value of the dollar rises. When demand is down, then the dollar is worth less.
A crude analogy to illustrated to change in value of the dollar
Assume there is a small town of 5,000 people in the middle to high income bracket that all live in apartments due to lack of available land for building homes. Then assume one home is finally built in the town and it is in very high demand. Would it be unreasonable for the asking price on the home to be at least 2 or 3 times as much as for a similar home in a large town that has plenty of housing? Could the price even go as high as 10 times as much or more? Well this is a crude example of how the value of the dollar also goes up when there are fewer dollars available to meet a rising demand by foreign investors wanting to purchase our treasuries, stocks, real estate, etc. Similarly, when there are many more dollars available than demand, then the value of the dollar declines – it is easy to find dollars to convert from their currency. In those times, foreign investors are not seeking to buy as many our things so there is less demand for dollars to convert with.
The current world-wide demand for dollars
With the world-wide financial crisis hitting most foreign countries harder than the U.S., investors in those countries want to buy U.S. issued securities such as treasuries that are backed by the full faith of the U.S. government. Since we have the largest economy in the world, foreign investors feel U.S. securities are the safest available, at least they perceive them more safe than investing in their own country. That is why the dollar has soared in value recently with so many foreign investors seeking these perceived safer investments that must be purchased with U.S. dollars.
Relating gold to the dollar to inflation
Currently, there is also a demand for gold since most investors around the world view it almost as a standard currency that is valued by everyone. That gives it a large base of investors that keep the price high, especially in times of high uncertainty such as the world is currently experiencing.
In terms of the dollar, you need to realize part of the price of gold rising can be attributed to times when the value of the dollar decreases. In those normal times, it is not so much that gold has risen in price, but that it takes more dollars to buy the same amount of gold. As an example, assume you can buy gold for $1,000 per oz. Later, the value of the dollar decreases by 10% to only be worth 90 cent when compared to what it was worth when purchasing $1,000 oz worth of gold. In this case, you would need to have $1,111 to buy the same oz of gold under the current lower valued dollar. This is derived by taking the $1,000 originally paid divided by 90cents for each lower value dollar meaning you will pay $1,111 using these lower value dollars for the same ounce of gold. So, it isn’t that gold has risen, but instead, gold has stayed the same and the value of each dollar to buy that gold has gone down. This is a time of inflation when the value of the dollar goes down, which is why prices paid for many things seem like they are going up
Relating gold to the dollar to deflation
This also works in the opposite. If over time the value of the dollar had instead increased by 10%, then each new dollar would be worth $1.10 of the older dollars. In that case, we take the original dollar paid $1,000 oz of gold and divide by the new $1.10 value dollar to only pay $909 per ounce of the same gold. In this case it looks like deflation since the price has decreased over time. This would also be true of many other items when the dollar increases in value as we are currently seeing.
Amplifying my point about the price of gold during inflation and deflation
An interesting observation I’ve made recently is in times of very high uncertainty, as we have around the world today, there is the added demand for gold that is also causing the price to increase on top of whatever the value of the dollar does. If the value of the dollar increases, as it has recently due to the high demand for our treasuries, gold has still increased due to high demand by investors around the world. So you can’t always only count on the straight mathematical price model I used above to calculate the price of gold during inflation and deflation.
Summary
Notice that many commodities follow a similar pattern during inflation and deflation where their prices move in the opposite direction of the value of the dollar, under normal market conditions. As the dollar rises, it takes less dollars to buy the same commodity like oil (affecting the price you pay per gallon for gas at the pump), silver, gold, etc. As dollars fall, it takes more dollars to buy the same items. Just a general rule to think about when investing – keep a close eye on the value of the dollar and world demand trends for the dollar (rising demand or decreasing demand).
Accredited sophisticated investors are very mindful of such trends before making investment decisions. Don’t let them take advantage of your fear when you sell or buy at the wrong time when they are doing the opposite. Continue educating yourself about the investments being considered and all factors that affect those investments.
I hope this article helps you to not just look at the price of gold or other commodities by itself. Consider the valuation of the dollar, world demand trends for both the dollar and the commodity being considered, etc. Look for patterns and relationships. Understand those well before moving forward. Be an educated investor and you will be way ahead of the ordinary investor who wants to “get in before it is too late” or “get out since it is going to crash”. Those are opportunistic times for the educated investor to do the opposite of the crowd.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13
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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
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.
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
Showing posts with label inflation. Show all posts
Showing posts with label inflation. Show all posts
Monday, February 9, 2009
Sunday, February 1, 2009
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.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/
- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
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
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.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/
- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
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
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