What does inflation have to do with our deep-seated opinions about, feelings on, and reactions to investment risk?
“Less is more,” is a minimalist mantra that some people, particularly the most materialistic among us, find difficult to comprehend. Yet, ‘less is more’ remains the human race’s solution to the worst ecological problem of our lives: The ‘inconvenient truth’ of temperature increases caused by rising carbon dioxide levels in Earth’s atmosphere because of our love affair with fossil fuels.
Droughts in some places, floods in others; glacier depletion, rising sea levels, and worsening air quality everywhere indicate the importance of shrinking our aggregate carbon footprint on the only planet we call home.
Yet in other arenas, ‘more is more’! Our economic system thrives when modest inflation (not a high level of it) exists. Economists rightfully dread deflation because it reduces present consumption which leads to deferred expenditure, a deceleration in the velocity of money, and thus to recessions or, worst of all, a depression. Hence the economists ’mantra might well be:
“High inflation, bad; low inflation, good; zero inflation, unstable; and negative inflation or deflation, bad!”
That is why central bankers work ceaselessly to keep their countries’ economic engines ticking over at healthily enough rates to generate inflation in the 1 per cent to 4 per cent range per year – the ‘Goldilocks zone’ for healthy economic performance.
While all that is well and good for national economies, where does it leave the smallest unit of economic activity, the individual? More specifically, where does that leave you and me?
Well, from the time we enter the workforce and begin earning our own way in the world, we aspire to make more and more money for two reasons:
Natural human ambition to rise up in the world;
Our need to stay ahead of inflation’s debilitating effects on purchasing power.
You know your own commitment to Reason 1. But as for Reason 2, let me point out some mathematically inconvenient truths. If inflation runs at precisely 1 per cent a year, it will erode our purchasing power by half in about 72 years. But if it runs at, say, 2 per cent, 3 per cent or 4 per cent, our purchasing power in each scenario falls by half in, roughly, 36, 24 or 18 years.
Furthermore, if we move away from national inflation statistics and consider our personal inflation rates, things may be worse because those often run within the 5 per cent to 6 per cent annual range. If that were the case, our personal purchasing power would fall by 50 per cent every 14.4 to 12 years! But what does this foray into ‘The Rule of 72’ have to do with our present and future lives?
When we toil actively in the workforce, we wish to enjoy a rising income that moves up faster than either the national inflation rate or our personal inflation rate.
What’s scarier, though, is what we need to do to thrive IN eventual retirement. In last week’s column, Scrutinising Your Building Blocks of Wealth, I explained the importance of using different asset classes within our PoW (Portfolio of Wealth) to generate different forms of passive income, such as interest from cash, dividends from stocks and EPF, distributions from unit trusts, and rental from investment real estate. You may read that column here:
Within the context of preparing as early as possible before retirement for your hopefully long years in retirement marked by rising prices and, sadly, rising planetary temperatures (and hence pricier air conditioning bills), we need to learn how to incrementally boost the total passive income we extract each year from our PoW.
THINGS TO UNDERSTAND
To do so, we should understand some asset classes are weak hedges against inflation because their yields are usually lower than inflation, while other asset classes are strong hedges against inflation because their long run yields are higher than inflation.
Interest earned from cash, for example, tends to be lower than our inflation rates, while dividends from stocks and rental from investment property and real estate investment trusts (REITs) tend to rise faster than inflation.
Yet there is a constraining complication. Lower yielding assets usually have more stable prices while higher yielding assets often exhibit rollercoaster price trajectories. Note: The older we grow in retirement, the less volatility and price uncertainty we generally care to stomach.
But since we will need more and more income in retirement as we move through our 60s, 70s, 80s, and hopefully beyond, we must learn enough about long-term investment market behaviour to internalise the key lessons of investment history: Diversification works and global markets always recover... eventually.
If we can’t learn and apply those lessons, we will have to rely increasingly on safe interest inflows that can’t keep up with inflation’s inexorable appetite. But if we can imbibe those vital lessons, we can utilise intermediate market dips and occasional steep collapses to wisely shift our asset allocation from safe cash and bonds to riskier stocks, real estate and perhaps commodities when their prices are temporarily depressed.
Bottomline: We can boost our passive income in retirement from our PoW through regular asset rebalancing so we consistently focus on buying riskier assets low and selling them high.
Next week we’ll explore the role of passive income in our goal to achieve true financial freedom.
© 2019 Rajen Devadason
Rajen Devadason, CFP, is a Licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via [email protected]. You may follow him on Twitter @RajenDevadason
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