Underperforming Assets Can Erode Purchasing Power
Edition: August 2001 - Vol 9 Number 08
Author: Richard Yercheck
Without careful planning, someone investing $10,000 in 1999 could be making a decision that substantially affects his or her finances for years to come. Combined with the effects of inflation, underperforming assets can erode the purchasing power of retirees, destroy college investment strategies, and eliminate hopes for early retirements.
Underperforming assets can be defined as those that, after inflation and taxes, provide very small or non-existent yields. In today's market, many short-term fixed income securities such as Treasury Bills and CDs fall into this category.
To avoid the loss of purchasing power, investments for the long term must provide capital growth, while at the same time beating inflation and taxation. When devising a strategy that protects purchasing power, it's extremely important to note that over the long run, even small differences in various investment yields can have a significant financial impact. In fact, underperforming investments that are not yielding maximum return for the level of risk involved can affect even the moderate investor's portfolio over the long haul.
For example, an investor who put $10,000 in 6-month CDs in 1980 saw an average annual yield of 7.84% by the end of 1998. At the end of 1998, that nest egg would have been worth about $41,604. If the same investment had been made in companies making up the Standard and Poor's 500, the return would have been 18.46%, or $221,547, almost 3 times more than the return on the CD investment.
Preserving Your Purchasing Power
Over the past 30 years, the Standard and Poor's 500 index has usually offered better returns than CDs and other fixed-income securities. Of course, to get that return, investors accept more risk, and because of the risk involved, many investors have traditionally believed that preserving capital should be their main objective as they reach retirement. As a result, they arrange for very conservative investments. This is a sound strategy, to a certain degree, but a preoccupation with preserving capital may lead investors to lose sight of a more important goal. Instead of preserving capital, preserving spending power should be paramount. Let me put it this way: A $500,000 retirement account earning 8% would yield a comfortable $40,000 a year. But assuming a modest inflation rate of 4.5%, the income would buy only $27,000 worth of goods in 10 years, $17,000 in 20 years and only $11,000 in 30 years. And with today's increased longevity, it's entirely possible to Certain short-term, fixed income instruments such as CDs, T-bills, money markets, and passbook savings accounts, for instance, generally are considered risk-free investments because they offer a guaranteed fixed rate of return. But from the examples listed, it is clear that there can be a risk in these investments. Because of the ravages of taxes and inflation, one risk is that, slowly but steadily, purchasing power will disappear.
Anyone who lived during the 1950s and 1960s understands the threat to purchasing power that inflation represents. During that time, Americans could purchase new automobiles in the $2,500 range, monthly electric bills were under $10, and annual auto insurance premiums were under $100. Those of you who don't go back that far only need to look at what items cost in 1970. Postage stamps were 6 cents; the Wall Street Journal was 15 cents; a Cadillac Sedan de Ville was $5,700; and a Super Bowl Ticket was $12. Think about what you have to pay for these items today. An annual average inflation rate of only 5% causes prices to almost triple every 20 years.
But you can preserve purchasing power by planning for capital growth to offset inflation. One of the best ways to do this is through high-quality stocks and bonds. An investment professional can help direct you to the right mix of investments for your situation, and can show you how a plan tailored to your individual objectives and risk tolerance is the best retirement plan for you.
About the Author: Richard Yercheck is a Financial Consultant with IJL Wachovia in Charlotte, NC. He can be reached for comment at 800-929-0724 ext. 9514. IJL Wachovia is one of the nation's largest full-service, regional, brokerage firms, offering a full range of investment services to investors.