Nick Foy, CFP®
A major part of our role as advisors is helping people balance different types of risks that can keep them from achieving their goals. Two of those that we work toward offsetting are market risk, and inflationary risk.
First, let’s define both:
Market risk: the risk of loss due to the factors that affect an entire market or asset class. Market risk is also known as undiversifiable risk because it affects all asset classes and is unpredictable.
Inflation risk: the chance that the cash flows from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation.
Both have the potential to significantly impact your ability to have the money to do whatever it is you want to do (become financially independent, pay for college, buy a new house), but the average person tends to focus on market risk far more, even if inflation risk is a bigger issue to contend with for the long-term investor.
Market risk seems really scary
Here’s how I consider it:
Lots of us are afraid of dying in a fiery plane crash. I actually enjoy flying, most of the time, but I think about it before (and sometimes during) almost every flight.
Thanks to FlightAware, we can get a pretty good picture of how safe flying actually is. Here’s a screenshot of flights currently in the air in the continental United States as I write this:
That’s a lot of airplanes in the air at any given time. Chances are pretty good that they’ll all land safely. But, just the fear of flying keeps many people on the roads and out of the sky. In fact, it killed another 2,170 people after 9/11 because many chose to drive instead of fly.
I think a lot of people look at market risk the same way they look at flying: Markets can be unpredictable, especially in the near-term. In fact, markets can gp berzerk. But over long periods of time, we actually have pretty solid data helping us understand how different asset classes have performed relative to one another, and they give us great insight into future expectations. For the long-term investor, the real risk isn’t market risk, it’s inflation risk.
Inflation risk – like eating a burger and fries everyday
Inflation is the erosion of the real purchasing power of your dollars over long time periods. It’s a silent killer, because people who think their money is “safe” (in a bank account, or a treasury bill, or under the mattress, or in gold) might actually be taking on gobs more risk than they even understand.
Inflation risk isn’t the fiery plane crash, it’s heart disease. Inflation is the burger and fries slowly eating away at your arteries, yet I think we often fail to understand how significant the risk of heart disease is.
“Heart disease is the leading cause of death for people of most ethnicities in the United States, including African Americans, Hispanics, and whites. For American Indians or Alaska Natives and Asians or Pacific Islanders, heart disease is second only to cancer.”
Just as heart disease slowly erodes our heart’s ability to perform its important function, inflation slowly wipes away the value of our money, without most of us even realizing it.
Here’s what it looks like when we consider the change in the price of a quart of milk over the past 100 years:
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this hasn’t been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.
Balance it all out
Investors need to balance out the near-term market risk with the long-term inflation risk, and have a portfolio appropriately allocated to handle both types of risk, along with the other myriad of risks investors face.