Lesson 6: Inflation: The Return Killer

Inflation: The Return Killer

November 26th, 2011 by

InflationInflation is the increase of prices over time. It is measured by the annual percentage change in prices, or more specifically the Consumer Price Index, which measures prices of different goods and services that individuals and families buy. In most cases, what costs one dollar today will cost more than a dollar next year. With this in mind if you haven’t taken action to protect the dollar in your pocket, you’ll find that it buys less and less, year after year. The solution is to invest your dollar to get a return on your investment that is greater than the rate of inflation.

When more money turns out to be less money

For truly positive returns, investments have to perform better than the rate of inflation. If they don’t, then even though you may have more money than when you started, that money will buy you less than the amount you originally invested.  This is where the concept of real vs. nominal returns come into play.

Nominal Rate of Return

The nominal rate of return is what you earn on an investment, not including inflation.  When people talk about return they are usually referring to the nominal rate of return.

Real Rate of Return

The real rate of return is what you earn on an investment, minus inflation.

Example

Lets say you buy a 1 year bond which pays an interest rate of 4%.  At the end of the year if you hold the bond for the entire 1 year period you will have $104.  The nominal rate of return on this investment is 4%.

Lets also say that in that same year inflation was 1%.  The nominal rate of 4% minus the 1% inflation equals the real rate of return on this investment, which is 3%.

Because of the affects of inflation, a large factor which determines the rate of return a fixed income investment pays, especially on longer term investments, are the future expectations of inflation.  When you buy a 30 year bond for example, the rate of return on that bond which is offered by the market is partially based on what the market anticipates inflation will be over the next 30 years.  If investors feel that the real rate of return is going to be negative (that inflation will be higher than the yield being offered on bonds), they will not buy the bonds. This in turn will force borrowers to raise the interest rates they offer to attract investors.

How Inflation Factors into Your Investment Decisions

If you have a confident view on where you think inflation is heading then this should factor into your investment decision process.  If  you think inflation is going to rise more than the market is expecting then you want to protect yourself by investing in fixed income instruments with shorter maturities.  This way when inflation rises you are not locked into a long term investment at a lower rate than than the market is currently paying.

If you think inflation is not going to be as high as the market is expecting, then you are going to want to invest in instruments with longer maturities.  This allows you to lock in the higher rate before the market’s inflation expectations adjust.  In addition to locking in a higher rate, as the market adjusts its inflation expectations lower and interest rates fall, the value of your investments which are locked in at the higher rate will rise.

If you feel there isn’t enough data on inflation at the moment to reach any conclusion, there are other solutions available.

Use a laddering strategy

You divide your investments among fixed income products with different terms (maturities), then roll each investment over into a new one to keep its maturity “laddered” with respect to the others.  We have an article which shows you how to ladder your portfolio here.

Buy bonds such as the Government’s TIPS (Treasury Inflation Protected Securities) and I series bonds

The income is fixed, but the principal is indexed on (increases with) inflation.   We have an article on Investing in TIPS here and an article on investing in I Bonds here.

Want more info on inflation? See our inflation charts here.

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