Thursday, May 31, 2012

Rethinking Risk and Inflation

Imagine what life would be like if you saw all amounts of money in terms of constant year 2000 dollars. Because there has been about 28% inflation since the year 2000, if your friend saw a jacket on sale for $128, you’d see the price as $100. While other people would see prices rising over time, you’d see the average prices of the things you buy stay roughly the same. Any cash that you keep hidden in your sock drawer would shrink slowly over time in your eyes. This change in your perception would have a number of interesting effects including your perception of investment risk.

While most people would see their pay stay constant for the year and then step up at raise time, you’d see your pay cheque drop by a little each pay period. At raise time your pay would go up, but not necessarily back to what it was at the start of the year depending on whether your raise exceeded inflation.

If you had a $10,000 emergency fund in a regular savings account that pays 1% interest (which is less than the inflation rate), you’d see the balance in your account drop slowly over time. The taxes you’d have to pay on the roughly $100 interest would be maddening because it would look to you like the interest rate was actually negative.

In fact, for all your investments the part of the return that makes up for inflation would be invisible to you. You’d only see real returns (returns above inflation). But you’d still have to pay taxes on the invisible parts of the returns on your taxable investments. From your point of view, higher inflation means higher taxes on phantom income.

When old people talk about the good old days in the 1980s when interest on savings was nice and high, you’d think they were crazy. After deducting the high inflation, returns on savings in the 1980s weren’t anything special, and there was the problem of paying taxes on a large amount of phantom income.

You wouldn’t understand people who claim that government bonds are safe as long as you hold them to maturity to get a guaranteed payout. From your point of view, these bonds would pay the “guaranteed” amount minus an unpredictable amount of inflation.

Standard annuities would seem crazy to you. Some financial advisor would suggest that you take your RRSP savings and buy an annuity that pays a fixed amount each month. But you’d see the monthly payments as dwindling unpredictably until there were almost guaranteed to be worthless after 30 years.

For most people, fixed-income investing looks like a struggle to get the most guaranteed income possible, but to you it would seem like a struggle just to prevent your savings from losing value without being able to draw an income. For you, the only way to generate an income and simultaneously maintain the value of your principal would be with riskier investments such as stocks. For you to choose to stay with GICs, bonds, and other fixed-income investments in retirement, you’d have to accept that your principal will dwindle over time and hopefully not run out before you die.

Currency-hedged ETFs would be quite puzzling. Your money would be invested in foreign stocks and you’d get their real returns except for an added (or subtracted) factor. This added factor would be the difference between inflation in your own country and inflation in the foreign country. As an added bonus, you’d lose a little of your return to tracking errors that come as a result of this added (or subtracted) inflation factor.

Overall your perception of money would be quite different from other people’s perceptions. However, you’d see the financial world much more clearly than others.

5 comments:

  1. This is one of your best yet. Simple, elegant, and convincing.

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  2. Products that provide a principal guarantee will make little sense because if one gets the principal back in 5 or 7 years, it's not the same as getting the same value back.

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  3. @Spock: Thanks. It felt right while I was writing it.

    @CC: Another good example. I'm sure there are others.

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  4. Simply, the higher the inflation gets the further along we are in a dollar crisis and the less our currency is worth, thus the less we can buy. The global inflation rate can also be a major factor that determines the amount of goods and services that can be purchased with your money both domestically and internationally.

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  5. You have an easy to read writing style, keep it up! :)

    However, back to the topic at hand - it's quite a valid "issue" you've raised; that our savings accounts could be passing in time with a 'negative' real interest rate but noone's complaining because on the tiny time scales we are concerned about in day-to-day life; we can't feel the effects. We can't see the effects. A positive NOMINAL interest rate is advertised by the Banks and everyone just eats it up.

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