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Understanding Inflation
Your Investments May Not Be Growing as Much as You Think
Inflation — the increase in the price of goods and services — can wreak havoc on a long-term investor's money. Unless your returns keep pace with inflation, your money's value erodes. An investment, then, should be evaluated not only for its return before inflation (nominal return) but also for its return after inflation (real return).
Nominal vs. Real Returns
Consider the nominal and real returns of three major asset classes found in most retirement savings plans: cash-type investments, bonds, and US stocks.
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- A dollar invested in Treasury bills between 1928 and 1996 earned a 3.9% average annual return. Yet, according to the US Consumer Price Index, inflation during that same period averaged 3.3%. The T-bills' real return? Only 0.6%.
- A dollar invested in long-term US government and corporate bonds over the same period earned a 5.7% average annual return. Less inflation, the real return is 2.4%. Better than T-bills, but not by much.
- A dollar invested in US common stocks over this period generated a 12.4% average annual return. The real return: 9.1%. That's three times better than bonds and head and shoulders above T-bills.
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Your Personal Bottom Line
Most discussions of investment performance focus on nominal returns. Yet your personal "bottom line" is how your investments perform after inflation is backed out. How would you react if you were told your $1-million nest egg will only buy what $200,000 does today?
The obvious lesson is stocks, based on their history, can potentially crank out superior returns above inflation compared to fixed-income investments (see Understanding Risk). So how concerned should you be about real returns? That depends in part on your retirement investment goal.
Real returns take on greater meaning if you're a long-term investor. The longer you have to invest, the more time inflation has to impact the return on your investment. Higher real returns put more money in your account to counteract inflation.
Real returns may be less of an issue if you've accumulated most of your nest egg and will soon start spending it. In this case, inflation has less time to erode your money's value. Still, it's probably a good idea to keep some of your money invested with the goal to achieve above-inflation growth. Retirement can last 20 years or more, and you don't want your savings to run short. Consider investments with real returns that keep pace with or are slightly ahead of inflation.
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