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Quiz!

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

1. Growth stocks
2. Real estate
3. Certificates of Deposit (CDs)
4. Bonds
5. Cash
6. Value stocks

What is Inflation Risk and How to Invest?

US inflation spiked to 4.2% in the past year (by April), more than double the Fed’s target and the average of the past 10 years. The Producer Price Index (PPI), that measures the cost of production, spiked even faster, by 6.2% over the past year. PPI movements tend to precede inflation (measuring consumer prices), meaning that even higher inflation is likely. There are a number of inflationary forces at play including government stimulus and low interest rates.

What is the risk of inflation? Inflation makes your money worth less, just like an investment decline. Unlike a decline in a diversified stock portfolio that tends to be a temporary event, inflation is a permanent decline. For example, in the 10 years 1973-1982 the purchasing power of Americans declined by 57% due to inflation. Unlike appreciating assets such as stocks, inflation does not enjoy sharp recoveries after steep declines. Add another decade to that period, and the inflation compounded to a 70% decline in the value of savings in those 20 years.

It is easy to forget the damage of inflation to your purchasing power after 10 years of below 2% annual inflation. Given that its damage is irreversible, it’s worth being well prepared. Some assets that may be at risk if inflation persists are:

1. Bonds with a fixed rate. The prices of these bonds decline as interest rates go up, and the decline is greater the longer the term of the bond.
2. Growth (high Price/Book) stocks that are valued based on earnings far into the future. This is especially true for the extremely expensive S&P 500 stocks that have valuations a mere 10% below the rare and extreme highs of 2000.

How can you invest with high inflation? To make up for losses to inflation you have to grow your money faster than the rate of inflation.

1. Stocks (company ownership) tend to be defensive against inflation, since the inflation is made up of prices of products and services that companies sell.
2. Real estate also tends to be defensive against inflation, since housing costs are part of the inflation calculation.
3. Value stocks (low Price/Book) tend to do better than growth stocks (high Price/Book) in inflationary periods, because their value doesn’t depend so much on earnings far into the future.

Quiz Answer:

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

1. Growth stocks [Correct Answer]
2. Real estate
3. Certificates of Deposit (CDs) [Correct Answer]
4. Bonds [Correct Answer]
5. Cash [Correct Answer]
6. Value stocks

Explanations:

1. Stocks sell products and services that are part of the inflation calculation, so they can do well on average. But, growth stocks (high Price/Book) are valued based on earnings far into the future. These earnings diminish in value faster with high inflation.
2. Real estate tends to go up with inflation, since housing costs are part of the inflation calculation.
3. Certificates of Deposit (CDs) have a fixed payment that becomes less valuable with inflation.
4. Most bonds have a fixed payment that becomes less valuable with inflation. Floating rate bonds don’t have this issue, but they have very low returns.
5. Cash declines in value directly with inflation.
6. Value stocks (low Price/Book) are not dependent on earnings far into the future when the inflation has the opportunity to compound the most. Their products and services are part of the inflation calculation, and become more valuable.

Quiz!

Which of the following are factors that determine investment returns (may be multiple answers)?

1. Past known world events.
2. Central bank actions.
3. Future unknown world events.
4. Valuations

What Determines Investment Returns?

Most investors focus on one factor when trying to predict investment performance: past world events. In reality, investments are impacted by different factors, including: future world events, central bank actions (the Fed in the US), momentum, valuations and the natural growth of companies. Here are a few scenarios that tend to surprise investors and lead to unexpected results:

1. Recently there was a negative event that led to declines. The next day brought a positive event along with gains. The reverse also happens.
2. Recently there was a negative event that led to declines. A central bank (the Fed in the US) took actions to support the economy, leading to optimism and gains. Even as little as indication for future support can lead to gains.
3. An investment is more likely to continue its trend of recent months. A high investment can keep going higher and a low investment can keep going lower.
4. An investment with low valuations is likely to enjoy greater than average gains in the upcoming 5-10 years. In addition, it is more likely to revert from negative momentum to positive momentum.
5. Beyond all factors above, you can expect diversified stocks to grow on average, thanks to the productivity of the underlying companies. It doesn’t happen in every specific day, month or year, but it happens on average, supporting long-term investors. And it happens more (on average) for certain groups of stocks including: small companies, cheap stocks (low valuations), and emerging markets.

Quiz Answer:

Which of the following are factors that determine investment returns (may be multiple answers)?

1. Past known world events.
2. Central bank actions. [Correct Answer]
3. Future unknown world events. [Correct Answer]
4. Valuations [Correct Answer]

Explanations: Past known events are already reflected in stock prices. Read this month’s article for further explanations.

Quiz!

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

1. Increased by 20%
2. Increased by 10%
3. Did not change
4. Declined by 36%
5. Declined by 54%

Is Your Growing Income Making You Less Financially Independent?

Say you earn $100k per year and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year. You double your saving rate from 10% per year to 20% per year. The table below shows the impact on your finances (all amounts are in dollars):

The paradox. You just doubled your saving rate, quadrupled the amount saved each year, have 57% extra to spend, yet you quickly become more stressed about money than before the raise! What happened? Your spending increased by 59% relative to your total savings, making you less financially secure and more dependent on your job. The stakes are higher, making work a lot more stressful. I believe that this is a big reason for rising stress and declining happiness along with rising incomes.

Is there a Solution? Yes. Instead of counting on potential earnings, increase your spending only (1) based on new money that you already saved, and (2) in a sustainable way. In the example above, you keep your spending at $70k right after the raise, and increase it only using 3% of the money that you already saved and invested. 3% is an example of a likely sustainable withdrawal rate from a diversified stock portfolio. The table below shows the progression over 3 years (all amounts are in dollars):

Key points:

1. Higher income never hurts financial security. This plan eliminates the big dip in financial security after the raise. Instead, it provides growing financial security. Note: Your overall financial security could decline during big enough down years for your investments, but this is not related to your increased spending. It is the result of owning volatile investments. Volatility is the price of high long-term expected returns. It can hurt you when between jobs, but should help while you are in saving mode (see: How to Use Volatility to Make Money http://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/).
2. Sustainable new spending. By increasing your spending by a small percent of new savings, the new spending is expected to be sustainable even in the face of severe investment declines.
3. Plan not reactive to investment volatility. The plan does not change spending along with the investment’s ups and downs. Declines don’t hurt spending, while gains are left to compound until you reach financial independence (retirement). When independent (spending/investments <= 3%), you can further increase your spending to 3% of your investments, whether you are working or not.
4. Relatively simple calculation. By tying your spending only to money you save from your income, the calculation stays relatively simple: Once a year, you can total your additions (minus withdrawals, if any) to your investment portfolio, and you can raise your annual spending by 3% of that amount. Your investment advisor should have this information, and do the calculation for you.
5. Reward for rising income. By tying your spending only to money you save from your income, you reward yourself for increases in income, instead of investments that you cannot control.
6. Spending, total savings, and financial security all set for growth. Thanks to compounded investment growth, the available money to spend, the total savings, and financial security, all should grow exponentially over time (beyond the dips during down periods in the cycle).
7. Baseline spending. The first step is setting your baseline spending. To find that, go over every item in your spending, and ask if you are willing to trade it with a more relaxed life. Once you completed all the trades (spending reductions), you maximized your financial relaxation. The lower the baseline, the higher your financial security, the faster it will grow, and the sooner you will reach retirement – the point from which you can keep growing your spending, independently of income.
8. Resolving the paradox of: higher income = more stress. Many people have strong desires for increased spending immediately as their income goes up, making this plan seem too extreme. If you feel that way, think about something even more extreme: the prospects of becoming more stressed and less happy “thanks” to your higher income. Keep this paradox in mind before rushing to add to your spending based on growing income and not actual savings.

Quiz Answer:

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

1. Increased by 20%
2. Increased by 10%
3. Did not change
4. Declined by 36% [The Correct Answer]
5. Declined by 54%

Explanations: Read this months’ article for an explanation.  Technical note:  The 59% increase in spending rate mentioned in the article is equivalent to a 36% decline in financial security: 1/(1+59%)-1 = -36%.