I first read about inflation generally following the price of a postage stamp in a book called The New Financial Adviser by Nick Murray. I don't remember who Nick Murray is but he knows his stuff and the book is a great read.To understand what inflation can do to your financial plan, just look at this chart and think of all of your expenses as being the cost of a stamp.
Over long periods this is what your expenses have done and this can serve as a template, with limits, to what the future might look like. It looks like a stamp cost $0.22 twenty years ago. Recently stamps just went to $0.42 (it was 42 cents right?), a gain of 90%. It is not crazy to think that twenty years from now that stamps could go up another 90% along with your expenses.
Your portfolio will need to go up by at least that much just to run in place. Is this reasonable? On June 27th, 1987 (a Saturday) the S&P 500 stood at 307.16, it closed yesterday at 1506.34 which is almost a five-bagger. The last 20 years have included a crash, a bubble and a couple of wars and the stock market completely dusted inflation. If you bought a bond 20 years ago you are getting your principal back.
From a numbers standpoint I think it makes no sense to own bonds. From an emotional wellbeing standpoint of course you need fixed income exposure but it is important to understand the numbers behind asset allocation so you can think properly about the long term. This is important for everyone including folks that have already retired.
A healthy 70 year old is likely to live a long time which means he needs to worry about inflation eroding purchasing power just like a 50 year old.
If this is new to you learn about it sooner than later.
22 comments:
Great article, as usual, and I particularly like the point about bonds. I believe it was Nassim Nicholas Taleb who made the point that holding bonds doesn't make a lot of sense. You may as well put your money in riskier assets with better returns and the rest in risk free assets. As a crude example, instead of a 70/30 S&P500/Bond market mix, maybe a 70/30 Small cap/ING Account mix.
Bonds? What are those?
Sincerely
Irrational Hedge Fund Manager
I own Loomis Sayles Bond Fund for my bond exposure. It's a multi sector bond fund that is riskier than the usual bond fund. Curious what you think about it.
The price of a stamp seems to be a reasonable proxy for CPI -- according the BLS CPI calculator at http://tinyurl.com/b5nga 22 cents in 1987 had the same purchasing power as 40 cents in 2007.
Personally I think inflation WRT most essentials -- shelter, medicine, food and energy -- is significantly higher than that so, assuming the goal is to maintain purchasing power and lifestyle (not necessarily a given), significantly better portfolio performance would probably be a goal as well.
OTOH there is inflation and then there is *INFLATION* -- want your portfolio to gain 595% YTD (you read that right), just move here (http://tinyurl.com/2ck5et) -- hmmm, then again, perhaps not.
PS: Still doing fairly well shorting mortgage lenders and home builders in my trading accounts, WCI most recently since it was pumped up beyond intrinsic value by a putative Carl Icahn takeover attempt (never can figure out what these guys are really up to so I never follow their play but sometimes that play can help you go a way you want to go). Strategic accounts are still hedged and lagging somewhat albeit still better than t-bills. Bonds are really getting pounded and whipsawed though, I don't even like thinking about my zero coupon positions, if it wasn't for the (small but real) possibility of deflation and the fact that it often pays to at least think about buying what you hate I swear I'd liquidate 'em.
re:LSBDX
hard to argue with the track record. The only thing I would wonder about is that the yield (according to Yahoo Finance) is 5.22 while the maturity is 13.94 years and the duration is 7.55 years.
While they have forgotten more about bonds than I'll ever know it seems like they are going very far out for 20-30 basis points above the money market?
RW the issue of things like healthcare inflation making things look bleaker is valid of course but since I found the stamp chart I really just wanted to address building blocks with this post.
I'm guessing the duration is a little misleading here. They are probably loading up on the fat part of the yield curve, while hedging with some longer term plays. Their portfolio convexity would paint a clearer picture.
Roger, I know you are a proponent of gaining your fixed income exposure in places other than bonds (at least I think I recall this). Two questions. First can you provide a basic framework of building a fixed income portfolio for someone who is within a few years of retirement or retired and secondly wouldn't owning other types of fixed income not named bonds really ratchet up the risk?
I understand the conundrum here that is being careful to not add to much risk while at the same time trying to beat and outpace inflation.
Johnny,
I have touched on this before if you want to try the search feature. I will try to get a refresher up on this for Sunday Morning.
The take is not don't own bonds, it is understand what they can't do which is protect purchasing power.
Bonds are a huge market in which many people invest. To the extent that "it makes no sense" to invest in bonds one is implicitly saying that all of those people are acting irrationally, which is reason enough to revisit the thesis.
There is a very real possibility of that chart going parabolic in the years to come. It doesn't look like the growing supply of dollars will shrink anytime soon with the amount of U.S. debt coming due in the years to come.
William, I said from a numbers standpoint I think it makes no sense but that they help emotionally.
Feel free to spell out a numerical argument as to why they DO make sense in the context of the post.
I think this furthers Taleb's point. Bonds are a bit irrational from a numbers standpoint. What I gather from him is that if you're going to be risky, be risky, if you're going to be safe, be safe. I've really been researching this idea quite a bit and do appreciate all of the comments so far.
A good argument for bonds is "past results are no guarantee of future returns." The market has been down for 15 years (or thereabouts) before. There is no reason it can't go down for 20 or more. You shouldn't put all your plans in that basket, but I think it is wise to at least think about it. I think if you want to say there is no "numbers" reason, you would have to say there has never been a 20 year period where bonds were better. Is this true?
The attractiveness to bonds is the decreased risk. However, the argument could be made that you can reduce the overall risk of a portfolio by adding other uncorrelated assets with higher returns. The result is a portfolio with bond-like risk, but much higher expected returns.
The other problem with investing in bonds is that when people talk about the relative low risk of bonds, they are only considering price risk - but not acknowledging inflation risk (which I think is the original point of Roger's post).
Roger.
I plan on being O.K. during retirement by loading up on the forever stamp. Will that stop myinflation worries? :->
http://www.usps.com/communications/newsroom/2007/sr07_011.htm
I do agree with you that bonds don't make sense. When stocks go up they lag behind. When stocks go down they get hammered too. I don't get the attraction. I also don't understand them like stocks, so I don't invest in them. I don't invest in anything that I don't understand.
I do own some of Fidelity's floating rate income fund that yields a somewhat safe 6.5% a year though.
And it's funny that you brought up this subject today since I was just researching the inflation adjusted bonds funds that are being talked about recently by some pundits. They are supposed to do well during inflationary times.
I'm still yawning though...
anon re fidelity's floating rate income fund....
Can you be more specific? Safe as a money mkt?
first, u.s. postage stamps may be a poor proxy for inflation as the u.s. constitution essentially grants a monopoly to the post office. yes, some of the monopoly power diminished with the advent of email and the emergence of fedex. however, i saw a presentation in the early 90s where the speaker indicated that he had studied literally thousands of different items and the only item in those thousands that did not show some evidence of price deflation due to productivity improvements was u.s. postage stamps (due to the monopoly pricing power).
second, roger what do you see as the risk in tips or other inflation adjusted securities?
risk to TIPS?
my guess would be poor total return, relative to other fixedincome products, during periods of below normal inflation.
Anon 6:19.
The Fidelity Floating Rate Income Fund is fairly safe. The NAV has gone down from 9.97 to 9.92 in about the last 6 months.
Here is a Morning Star review:
http://quicktake.morningstar.com/FundNet/Snapshot.aspx?Country=USA&Symbol=FFRHX
And...
http://moneycentral.msn.com/detail/stock_quote?Symbol=FFRHX
Here is Fidelity's take:
http://personal.fidelity.com/products/funds/mfl_frame.shtml?315916783
Now might be a good time to buy as it is near it's yearly low in price.
I almost forgot to mention that this fund is Adam Bold's (the Mutual Fund Store) favorite fixed income fund.
http://www.smart401kadvice.com/?&js=Google&jk=The+Mutual+Funds+Store&jkId=3009721022&jagId=587670062&jmt=1&jt=PPC&&gclid=CLXKpZ3igo0CFSQWgQod1jyQhQ
FFRHX does hold mostly junk bonds. Fidelity Cash Reserves would be much safer, and after expenses would only yield less than 1 1/2% a year.
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