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Beware of Inflation

Imagine you have $1,000,000 saved, and you live in a fantasy world where there are no taxes. You need to take out $40,000 each year for expenses, adjusted for inflation. This is a very reasonable 4% starting withdrawal rate, and you can get 5% a year risk free and tax free on your investments.

Everything should be fine, right? Indeed, after 10 years your balance has grown to about $1.06 million and you feel comfortable. Then a funny thing happens. Your balance starts to decline, slowly at first and then faster. You are broke after 37 years.

What happened? Even though the rate of appreciation on your investments was higher than inflation, because the money you spent was not able to grow, the inflation rate on the expenses eventually overwhelmed the portfolio. Had inflation only been 2%, it would take 48 years to go broke. Only when inflation is down to about 1% does the portfolio continue to grow indefinitely in this scenario.

Inflation is the greatest destroyer of wealth in the history of the world. It will destroy much of yours as well. Do not underestimate it when you are planning, especially regarding asset allocation decisions.

Due to the power of compounding, inflation has a much greater impact in long time horizons than it does in short ones. Especially if you have a long time horizon (more than 30 years), don’t assume that everything will be fine as long as your investment return is higher than your original withdrawal rate. If inflation rears its ugly head, even if your returns outpace it, you will still run into trouble.

More people go broke because they invest in “safe” bonds and annuities than because of poor stock returns. This is because of poor planning regarding inflation.

In our managed portfolios we often use inflation protected securities for a significant portion of fixed income allocations. A small allocation to “hard assets” or “alternatives” such as real estate or gold also provides a meaningful inflation hedge. But the best hedge for most people remains growth – which usually means stocks.

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