When is a Dollar Not Worth a Dollar?
Conservative investors think they can avoid the big risks of a volatile market by placing their retirement funds in "safer" places like passbook savings accounts, certificates of deposit (CDs), or money market funds. And while they may help limit the risk of losing money in the market, they may be exposing their investments to another risk — inflation.
What is inflation?
Inflation is an increase in the cost of virtually everything. It makes the money we use worth less over time, because we have to spend more every year to buy the same things. Inflation is usually stated as a percentage increase for the year.
For example, in 1998 the average price of a loaf of bread was $0.86, and in 2008 that loaf of bread would cost $1.28. During the same period the price for a pound of bananas increased from $0.47 to $0.521 — only a five-cent increase, but more than 10% of the total cost.
Inflation vs. rate of return
It’s clear that your investments need to grow at the rate of inflation, or higher, if you want to retain purchasing power.
The difference between your investments’ total rate of return and the inflation rate is often called the real rate of return. So, let’s look at an example:
If an investor averaged a 10% rate of return, and inflation was 3.5%, the real rate of return is 6.5%.
If the same person took $100,000 from under the mattress and invested it with an annual real rate of return of 6.5%, it would be worth about $350,000 — in today’s dollars — after 20 years.
So when you are investing, make sure you are accounting for the impact of inflation on your money. Conservative investments, while safe, may not offer you enough growth to beat inflation, and you could end up with less purchasing power in retirement.
This illustration is hypothetical and is not intended to serve as a projection or prediction of the investment results of any specific investment. If the costs of investing were reflected, the return would have been less. Investments are not guaranteed. Depending upon the underlying investments, returns could be higher or lower.
So what are you to do?
Conservative investments may be OK when your financial goals are short term and won't have time to weather the market’s downturns. But if you're investing for the long term, you should consider the impact inflation is going to have on your plan. All investing involves market risk, including possible loss of principal. Your investment professional can help you set up a long-term investment plan that considers inflation risk.
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1Consumer Price Index Average Price Data, http://data.bls.gov/cgi-bin/surveymost?ap (downloaded 10/24/08).
