Inflation Risk

Inflation is actually less of a risk and more of a certitude. The risk is that one's savings and investments might not have the spending power in the future that one had hoped.

At 3% inflation, the value of a dollar will drop below 50 cents in about 23 years. At 5%, this halving of worth occurs in roughly 14 years. Even at the relatively comfortable pace of 2%, one's ability to purchase goods and services with a given amount of money drops by a third every 17 years or so. The chart at right is demonstrative. $1,000,000 set aside in 1976, uninvested, would by 2006 have shrunk in real value to $265,809.

Most of us save to have more in the future, not less. The need to accumulate more is exacerbated, moreover, by continual increases in life expectancy and probable reductions in social security benefits when actuarial realities are ultimately worked into the FICA system.

Thus, when establishing your comfort zone when allocating assets, in addition to goals and investment risk, consider the impact of possibly decreasing wealth and lifestyle levels should your investments not keep up with inflation. The chart below shows how $1,000,000 invested at the end of 1976 would have grown, in real terms (net of inflation), over time if invested completely in either stocks (S&P 500), bonds (10-year treasuries), or cash equivalents (3 month treasury bills).

As you can see, equities have clearly proven to be a superior vehicle with which to grow wealth. Though occasionally fraught with volatility and decline, these past 30 years saw equities provide a 12.35% nominal rate of return and a 7.99% real (inflation adjusted) return. Bonds provided less than half the real return and cash outpaced inflation by less than 2%. In fact, in some years, cash instruments did not even keep up with inflation.