Inflation is a risk we have to face in financial planning, particularly in retirement.  We need to measure inflation risk correctly to be able to make reasonable financial plans.  The best guide we have to the future takes into account past inflation statistics.  But the field of statistics is full of subtleties, and even Dimensional Fund Advisors (DFA) can make mistakes. DFA creates good funds, and their advisors tend to do good work for their clients.  I’d prefer to find errors in the work of a less investor-friendly investment firm, but they provided a clear example to learn from.  They misapplied a statistical rule, and as a result, they misinterpreted the history of inflation over the past century. I discussed this issue with Larry Swedroe in posts on X.  I respect Larry and have followed his work as he tirelessly explains evidence based investing to the masses. A Simple Example To explain the problem, let’s first begin with a simpler example.  So...

As we’ve learned in recent years, inflation can rise up and make life’s necessities expensive.  Despite the best efforts of central bankers to control inflation through the economic shocks caused by Covid-19, inflation rose significantly for nearly 3 years in both Canada and the U.S.   Uncertainty about future inflation is an important risk in financial planning, but most financial planning software treats inflation as far less risky than it really is.  This makes projections of the probability of success of a financial plan inaccurate.  Here we analyze the nature of inflation and explain the implications for financial planning. Historical inflation Over the past century, inflation has averaged 2.9% per year in both Canada and the U.S.(*)  However, the standard deviation of annual inflation has been 3.6% in Canada and 3.7% in the U.S.  This shows that inflation has been much more volatile than we became used to in the 2 or 3 decades before Covid-19 appeared...