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A 'Back to Basics' Approach to Long-Term Inflation Risks

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Inflation might not take much of a bite out of your wallet today. But spiraling prices over longer periods can eat away at a portfolio's gains, in the process eroding your nest egg's value and undermining any efforts to reach a secure financial future.  

The impact of rising prices can hit you in different ways. For example, inflation's rise is often rather subtle and spread across hundreds of different products and services. Just consider how much of a chunk it has taken from a typical consumer's 'buying power' over the past two decades. Prices for basic items such as prescription drugs, home insurance, veterinarian services and real estate taxes have shot up between 120% and 252% since 2000, according to a recent Senior Citizens League study.1

The same corrosive forces are at-work in the long-term investment planning process. Along these lines, IFA's wealth advisors find putting money to work in equity markets to be a particularly effective way to battle the ravages of long-term inflation.

Consider the graph below, which compares how a large-cap index of U.S. stocks would've protected a hypothetical investor against the ill-effects of inflation over an extended timeframe. Starting in 1928, the value of $1 as represented by the IFA SP 500 Index rose to $4,515 by the end of 2019.

In this same 90-plus year period, $1 put into a relatively low-risk one-month U.S. Treasury bill would've also shown a positive outcome, albeit at a much lower growth rate. It increased in value to $20.28 during this timeframe.

Such a fixed-income investment, however, ran a fairly close race as opposed to the rate of inflation. Of particular note: This period included a significant drop in the Consumer Price Index during the Great Recession years. Even so, prices increased by more than 14 times the index's original value to $14.85. 

At times, though, a stock portfolio can run into headwinds fighting inflation. For example, during the 17-year period from 1966–1982, the annualized return of the IFA SP 500 Index was 6.86% before adjusting for inflation. After taking into account the impact of rising prices (as measured by the CPI), that gain was reduced to 0.04%. 

And many long-term investors will probably remember the "lost decade" from 2000-2009. In this period, the annualized return of the IFA SP 500 Index dropped from –0.96% before inflation to –3.40% after inflation.

Some investors might try to time such bouts of inflation by using a range of alternative fund strategies, from commodities and hedge funds to private-equity. 

In one seminal study about "liquid alts," researchers at Dimensional Fund Advisors found such alternatives too frequently charge much greater expense ratios than a typical "long-only" stock fund.2

These are considered the "hard" costs that investors run into. Prospectuses, though, don't reflect all of the actual trading costs associated with mutual funds. These so-called real costs include high-volume trading and other market impact costs associated with fully implementing a fund's strategy. 

We can estimate the impact of these types of costs by looking at a fund's annual turnover ratio. For example, a rate of 100% means that a manager turns over the entire portfolio in one year. Along these lines, it's worth noting that DFA's research also identifies liquid alts managers as showing a greater tendency to produce relatively high turnover rates. 

Given the added complexities and general lack of transparency in design and execution, IFA's Investment Committee remains confident that stock funds -- not liquid alts -- are the best investment vehicles to overcome the nasty aftereffects of long-term inflation. 

Rather than trying to get too exotic and invite more risk-taking in your portfolio, IFA urges you to take a more practical and "back to basics" approach to countering inflation. Simply put, this comes down to investing in a globally diversified portfolio of index funds tilted to factors that leading academic research shows are key drivers of longer-term returns.  

As part of devising a strategy to most effectively combat the harmful long-term impact of rising prices, we suggest that investors feel free to start an ongoing conversation with an IFA wealth advisor about creating a comprehensive and individually tailored financial plan. It's a service we offer to all of our clients at no extra charge

Footnotes:

1.) The Senior Citizens League, "2020 Loss of Buying Power Study," September 2020. 

2.) Dimensional Fund Advisors, "Alternative Reality," Aug. 1, 2018. 


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance.  For more information about Index Fund Advisor, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.