Friday, 27 November 2009

Cash: The real enemy of investors is not fluctuation of principal, it is inflation!

Many investors confuse safety of principal with a "sure thing investment."  Cash accounts provide investors with peace of mind because their principal does not fluctuate in value and because interest is added to the account on a periodic basis.  The institution providing the savings vehicle invests the money deposited by the investor in loans and bonds.  They take the dual risks of volatility and loss of capital - not the investor.  Unfortunately, investor peace of mind is an illusion, because the real enemy is not fluctuation of principal, it is inflation!  And "cash" investments do not keep pace with inflation!  As inflation robs investors of their purchasing power they must invade principal to buy the goods and services they need to live.  As the years go by, the investors' peace of mind is replaced by fear as they continually dip into their principal to pay for lifestyle expenses that rise with inflation.

In fact, cash flunks one of the most important tests we set for our perfect income investment.  In exchange for safety of principal and liquidity, the returns on cash are generally very low.  In fact, at current rates, the return on most cash alternatives isn't even as high as the rate of inflation, as measured by the Consumer Price Index (CPI). 

On December 31, 2003, the average yield on a 30-day Treasury bill was a paltry 0.85 percent while the annual rate of change in the CPI was 1.88 percent.  In other words, the interest on your money, would not be sufficient to replace the purchasing power you're losing to inflation.

Even if you think cash passes the safety of principal test because your principal does not fluctuate in value, it fails three other important safety tests.
  • First, the safety of cash begins to look suspect if you're losing the true value of your money - the ability to buy the things you need - because of inflation.
  • Second, since the yield is so low, the income generated by cash is not sufficient to buy the goods and services you need, which will force you to liquidate your principal. 
  • Finally, the false illusion of safety is compounded because the low yield on cash is further reduced by taxes.  Worst yet, you will pay tax at your highest marginal rate.  Unfortunately the combination of a high tax rate and a low yield only increase your need to liquidate assets. 
So much for safety!

The more you study the inflation problem, the more you realize how important it is to a successful retirement plan.  Inflation has been pretty tame over the past 10 years, averaging only 2.75 percent per year.  Don't be lulled into a false sense of security and allow yourself to think that inflation is not going to be a big problem for you in the future.

In the 1970s inflation averaged just over 7.4%.  By the 1990s inflation had moderated to an average of just over 2.9%.  Still, the average inflation rate for the entire 30-year period from 1972 through 2002 was 5.12%.

Just a small increase can be crushing to retirees.  You would need to invest a lot more money initially in a cash investment to provide enough interest to be reinvested against the day when you need to take more income to keep up with rising costs.

Inflation is the Retired Person's Greatest Enemy

1972-2002 (30 years)  Average inflation rate 5.12%
1982-2002 (20 years)  Average inflation rate 3.36%
1992-2002 (10 years)  Average inflation rate 2.75%


Let's say you had an income need of $3,000 per month and you noticed that you could buy a five-year CD with a current yield of 4% (a generous assumption based on current yields).  To generate an income of $3,000 per month or $36,000 per year, you would need to deposit $900,000 in the bank.

The first year everything seems to work well, but in the second year you notice two problems:

1.  You had to pay taxes on your interest income, and you had not factored that into the question.  Where do you get the tax money?
2.  Your living costs are rising, and you forgot to factor in inflation.  If inflation averages just 3% for the first year, your annual expenses would increase by an additional $1,080, compounding your income need.  After only the first year, you would have to start liquidating principal to buy the same goods, and services you enjoyed the year before.

Safe but Sorry

Over the years we have seen many people make the same big mistake - they opt for the safety of principal that cash investments offer and ignore inflation risk.  Inflation robs them of the purchasing power of cash; this illusion of safety would cost dearly.  When interest rates drop, they maybe forced to dip into their original capital.  The more principal taken out, the less income will be produced putting them on a slippery slope. 

The classic problems of:
  • low yield,
  • high taxes and
  • no inflation protection
 are pretty common to all types of fixed-income investments. 

Bonds start out with a little more income for each dollar invested, but suffer the same defects that cash investments do.  And, although it may not be widely understood by most investors, bonds can also suffer from high volatility and risk under the right circumstances.

Is there another option to meet your income needs without impairing the capital base?  We shall take a look at the difference dividend paying stocks can make.  As an investor in dividend-paying stocks, you not only get to keep more of what you earn from dividends becasue of lower taxes, but it's likely your dividend income and value will increase over time to keep you with inflation.  These exciting fundamental benefits are also available in dividend-paying stocks for growth.

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