Finding the Right Balance Between Inflation Risk and Investment Risk
When we talk about retirement risks, people often tend to fixate on their investments. Yes, investment risk is important, but it’s only a piece of the puzzle. The primary risk to your retirement is not having enough money to do what you want.
Like I said, investment risk certainly plays into this, but you need to look at the broader risk picture. One of the most insidious of these other, less obvious risks is inflation risk.
Everywhere you look, prices are going up—at the gas pump, toll booth, restaurant, movies. My wife and I had a date night not too long ago and movie tickets alone cost me $30. It’s hard to imagine it cost my grandpa less than a buck to take my grandma to a film when they were dating.
But inflation is a fact of life. The price you paid for something as a kid is significantly less than what you pay for that same thing now, and the price will be even higher in thirty years. Even if you aren’t actively paying attention to prices, it still doesn’t come as a surprise.
Inflation risk—the possibility that your money won’t carry the same buying power in the future—is a particularly insidious piece of the retirement risk puzzle because it works in tandem with investment risk.
As you move to more and more conservative investment portfolios to try to protect yourself from market volatility, you give up higher expected returns that could protect your spending power. So as investment risk declines, inflation risk increases.
This is often a fine tradeoff. But, just like anything, you can have too much of a good thing. Eventually, your investment risk could get so low that you are taking more inflation risk than you are probably comfortable with.
How Can You Avoid Inflation Risk?
To counteract this, you need to keep some investment risk in your portfolio, in the form of riskier assets with higher expected returns so your money has the chance to grow faster than inflation. You’re going to have some risk in your investment portfolio, so you may as well get paid for it.
Imagine a conservative investor who wants to minimize her investment risk as much as possible. She chooses to invest all of her money in One-Month US Treasury Bills—generally considered to be the closest thing to a risk-free investment in the market (and usually a better return on investment than most money market funds). What would have happened to her historically over rolling thirty-year periods?
In the 61 rolling thirty-year periods from 1926 to 2015, inflation (as represented by the US CPI) outpaced their investment portfolio 23 times (38% of the periods). In other words, they would have had to save more than a dollar for every dollar they wanted to spend.
This may be a tradeoff you are comfortable with, but it’s not feasible for the vast majority of Americans. What if we add in a small allocation to stocks to the portfolio?
|Number of Periods Lost to Inflation||% of Periods Lost to Inflation||Annualized Return||Standard Deviation|
|100% One-Month US Treasury Bills||23||38%||3.42%||0.88%|
|90% One-Month US Treasury Bills 10% S&P 500 Index||11||18%||4.23%||2.03%|
|80% One-Month US Treasury Bills 20% S&P 500 Index||0||0%||5.00%||3.82%|
Data from January 1926 to December 2015. Annual thirty-year rolling periods. Data for illustration purposes only. Indices are not available for direct investment. Past performance is not indicative of future performance. Data courtesy of Dimensional Fund Advisors.
While you are clearly taking on more investment risk by adding equity to your portfolio (the 80/20 portfolio’s standard deviation is almost 4.5 times greater than the One-Month T Bill portfolio), you’re reducing the level of inflation risk in your portfolio.
We can all but count on having to deal with inflation in the future, too. Using the same thirty-year period as before, we can estimate the effects of future inflation using Monte Carlo analysis.
How Much Will a Dollar Be Worth in 30 Years?
Assuming that the distribution of annual inflation rates stays relatively stable (which is always a risky assumption), on average, you’ll need $2.41 at the end of the thirty-year period to match the purchasing power of $1 today. The thing is, the future is wildly uncertain, but that’s one of the great things about Monte Carlo analysis—we can get a sense of a range of outcomes.
To incorporate this uncertainty, we can look at the range of results. In this analysis, half of the results (75th to 25th percentiles) showed that you needed to have between $2.74 and $2.04 to have the same purchasing power as $1 today. The majority of the results (90th to 10th percentiles) say you would need between $3.13 and $1.80.
|Percentile||Amount Needed for $1 Purchasing Power in Thirty Years|
But that’s not the whole picture. As you age, health care costs will become a larger part of your spending, and health care expenses tend to grow much faster than everyday costs as measured by the US CPI. Though, to be honest, with everything that is happening with our health care system it’s pretty difficult to estimate what health care inflation will look like in the future.
Whatever inflation ends up looking like in the future, you want to manage the risk of inflation eroding your purchasing power. Saving $2.41 now for every dollar you want to spend in the future is not a very appealing prospect.
So How Much Risk Is Enough?
To avoid this, you need to be willing to include at least some risky assets like stocks in your investment portfolio. It doesn’t have to be a lot—remember a 20% stock allocation in the S&P 500 Index hasn’t lost to inflation over any thirty-year period (so far)..
 Monte Carlo is a statistical technique that uses a large number of simulations to estimate what will happen in the future. It cannot provide definite answers. For this simulation, we used an average annual return of 2.99% and a standard deviation of 4.08% for inflation. These numbers were the average annual return and standard deviation of the US CPI from 1/1926 – 12/2015. Data courtesy of Dimensional Fund Advisors. We ran 10,000 simulations to generate these results. Data for illustration purposes only.