Inflation Risk: Long Term Asset Preservation
Welcome to the Alternative Wealth Podcast, where we unpack important personal finance, investment, and retirement topics so you have the knowledge to make critical decisions regarding your wealth. I'm your host, Ryan Colden. Let's get into it.
Today, we're going to be diving into the silent threat individual investors fail to think about. Specifically, that threat is inflation and why investors need to be concerned about the risk-free rate. Today we'll review the risk associated with the loss of purchasing power, some monetary theory and why inflation is a feature of the dollar and not a bug, then we'll explain how you can use this information to construct a portfolio to achieve your financial goals.
So I'll start off by asking you, do you routinely measure the risk associated with your portfolio? Because most individual investors have zero clue how to measure risk or the risks that are present in their portfolio. Focusing on an investment's potential return without accounting for its corresponding risk is not how professional investors conduct in business. And it leads to most investors overpaying for assets or just simply making bad investments.
Now, there are many different risks that can be present in a portfolio. One of the most important risks to mitigate against is the loss of an investment return due to inflation or inflation risk. And most people do not fully understand how big of a risk inflation is to their portfolio unless they have an understanding of how our banking system and our monetary system functions. We're going to dive into monetary theory in a minute, but first I want to give you a quick explanation of inflation and an example. Inflation is the loss of purchasing power of a currency, and in our case we're specifically talking about the US dollar, due to an increase in its supply.
So let's run through a quick example. Let's say in the beginning of 2024 that you have $50. And by the end of that year, you invested those $50 and it grew to $52. At first, it seems like you did well. You grew your money by 4%. But let's also say at the beginning of that year, instead of investing, you could have taken that same $50 and you could buy a week's worth of groceries. And by the end of that year, those same bundle of groceries now cost $52 per week. In this example, your financial position hasn't really increased by 4%. It stayed the same in terms of real purchasing power, as the increase in your amount of investments is offset by an equivalent loss in your dollars purchasing power.
Now, so now that we understand inflation, let's kind of dive into monetary theory, the Federal Reserve, and what that what all of this means for you as a long term investor. So monetary theory is incredibly dense. Quite frankly, trying to understand how our banking system works is incredibly hard to do and complex. But I'm going to try to do my best to simplify it in like a basic 101 version right now.
So to start with, in 1977, Congress amended the Federal Reserve Act, creating the dual mandate for the Fed. It reads as the following. The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth in the monetary and credit aggregate consumerate with the economy's long-run potential to increase production so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. In recent times, price stability has been defined by the Federal Open Market Committee with an inflation target of 2%. So keep that in mind, 2%. It's important also to point out that the U.S. came off of the gold standard in 1971, which enabled the Fed the ability to expand and contract the money supply with very little difficulty. The U.S. dollar is a fiat currency. It is not backed by anything other than the U.S. government's promise to make good on its debts.
So the primary way that the Federal Reserve expands the monetary base or creates new money in the banking system is by the Fed increasing its own balance sheet through the purchase of financial assets. things such as treasury notes, bills, bonds, mortgage-backed securities, and other government agency securities. So the Federal Reserve goes to the open market, they buy these assets, and in exchange, they're injecting dollars into the banking system. So the Fed gives dollars to financial institutions, which creates an initial monetary base. Now, once that initial monetary base is created, it is then multiplied exponentially by the banks through a process called fractional reserve banking, which fundamentally is dependent on using debt and leverage. This is important because whether you like it or not, we have a debt-based economy, and you need to understand this in order to win long run as an investor or simply just not to lose.
So currently, the Fed's reserve requirement for depository institutions is 0%. But to simplify an example, let's say the reserve requirement is 10%, meaning that if a bank has $100 million of bank deposits, it can lend out 10 times that amount, or $1 billion. Those lended dollars did not exist before, but have been created and lent out into the economy. This process repeats itself over and over and over again, growing the money supply. As money is created, either through the Federal Reserve's open market operations or through bank lending, a portion of those dollars end up in all different types of assets, such as stocks, equities, real estate businesses, driving those prices higher, creating asset inflation.
So here's the bottom line. As overall debt increases, so does the overall supply of money. If debt goes up, so does the supply of money. If debt goes down, the supply of money contracts. Why is this important to you as an individual investor? Because if we understand this, then what we take away is that the money supply is not tied to the total value of goods and services in the economy. it's tied to the total amount of bank issued debt. And as we covered earlier about the Fed's dual mandate, the Fed has an inflation target of about 2% a year, meaning if you did nothing else, if you kept all of your money in cash, you would actually lose about 2% of your purchasing power every year. Even though the number in your bank account would not change whatsoever, you actually would lose the ability to purchase. You would lose your purchasing power. As the price of goods and services in the economy would go up by about 2% annually.
So with knowing all of this, what can we do as long-term investors to set ourselves up for success? Investors can expect to earn higher than inflation adjusted returns by investing with an equity bias. and this is what we covered in last week's episode. However, rather than making the case for long-term investing with an equity bias, this week I want to focus on potential risks to be aware of with overallocating to fixed income. To be clear, I am not making the case against fixed income. I am making the case against having too much of an investor's portfolio in fixed income. And I see this very commonly with pre-retirees and retirees who have a false sense of security with being in 100% fixed income or 100% in cash because they don't have a good understanding of the risks associated with inflation.
Now, when it comes to portfolio creation, we always have trade-offs. In the short term, we can purchase assets that have low levels of volatility and create a stable portfolio that allows us to have a sustainable, dependable source of income. However, an over allocation to low risk investments in the long run creates a scenario where portfolio returns are insufficient to maintain purchasing power. In short, we won't be able to keep up our portfolio's returns with inflation. So when building a portfolio, we need to balance income and capital preservation needs against the need to sustain long-term purchasing power. And this is ultimately done by identifying your individual portfolio asset allocation.
With that in mind, let's go back to talking about inflation. The long-term rate of inflation from 1961 to 2024 is about 3.8% annually, or we can just round up to 4% to call it, to make it easy. Meaning if you just held cash from 1961 to 2024, you would lose on average 4% a year in purchasing power.
So now with that said, I want to cover the risk-free rate and why it matters to portfolio construction. It's commonly accepted within the finance industry that the current nominal rate of the 10 year US treasury is the risk free rate, meaning this is the theoretical rate of return you can get with taking on zero risk. However, I'm going to make the case right now that the risk free rate is not risk is no longer riskless, is not risk free due to inflation. The real risk-free rate of return after accounting for the inflation rate is somewhere in the ballpark of 0-2% annually, and sometimes it's actually a negative real rate of return, it really just depends on what time frame you're observing. In other words, inflation almost completely eliminates the real rate of return of US treasuries. So the risk with being over allocated to fixed income is the loss of purchasing power due to inflation.
The simple fix to this is to construct a portfolio with a strong equity bias to earn higher returns than inflation, while also balancing your income needs. The other phenomenon to be aware of is that although equities do provide a good long-term buffer or protection against inflation, this isn't necessarily the case in the short run. Equities seem to not perform very well in the short run with high inflation. However, other assets such as real estate, there's maybe a couple other that aren't really coming to my mind right now, they may provide a better short-term solution to inflation over equities, again, just in the short run. And again, everything comes back to asset allocation and building a portfolio that is resilient in all economic conditions. This allocation is unique and individual to every investor as well as institution and is based upon your financial situation and your goals.
So to recap, today we went over the risk that a loss of purchasing power presents to a portfolio, we went over some simplified monetary theory, and we also discussed how you can counter the effects of a loss of purchasing power by being aware of the risks associated with long-term fixed income investing. Hope this provided some context on how you can construct a portfolio to mitigate the effects of inflation and achieve your financial goals. Until next time, take care.
Hey, real quick before you go, thanks for listening and please remember to hit follow on your podcast player. You won't miss any episodes and it helps support us bring you the show. Today's show notes and resources are available to you by clicking the link in the description. The opinions and views expressed here are for informational purposes only and is not tax, legal, financial, investment, or accounting advice. This material is educational in nature and should not be deemed as solicitation of any specific product or service. All investments involve risk and a potential for a loss of principle. Should you need such advice, please consult with a licensed financial, tax, or legal professional. Neither host nor guest can be held responsible for any direct or incidental loss incurred by applying any of the information offered.
