August 12, 2011 by wcobserver
The story is told of a bow hunter out in the Rocky Mountains who shot an elk, but the arrow merely wounded it. The elk, having identified the source of his trouble, set about to eliminate it. He charged the hunter, who promptly dropped his bow and took refuge in a hole in the rocks. Every time the hunter would emerge the elk would charge again, whereupon the hunter would duck back into the cave. His companion called out from a safe distance: “why don’t you stay in the hole?” He replied “I can’t because there’s a bear in it!”
I share that with you as a parable for the modern-day investor, who is on the horns of a dilemma. Let the elk represent market risk, the cave is the refuge of guaranteed deposits, and the bear is inflation. What are treasure hunters to do?
Inflation is usually defined as a general increase in the cost of goods and services. Historically, the stock market and real estate have been seen as ways to beat inflation. During the ‘80s and ‘90s we enjoyed hefty market gains. It looked like our stock mutual funds were a great place to have our retirement account. We grew accustomed to average annual returns in the 12-15 percent range. Hunting was good. Then as the new century dawned, the market turned on us like that wounded elk. Many of us dropped out of the hunt, and looked for a safe hidey hole for our money. We are coming to realize that there’s not much comfort there, either.
Official government statistics show that inflation is low by historic standards. To which the average consumer retorts “well, you could of fooled me! Look what I’m paying for gasoline and groceries.” Your grandfather probably told you about hard times during his day, too.
To illustrate the impact of inflation, let me take you back a half century. It’s 1961, JFK is President, and the Kingston Trio is the hottest thing in folk music. A hard-working slob might make $100 a week, but many people would have sold their souls for that much. A $5,000 life-insurance policy covered a year’s salary. A new car cost about $3,000. Fast forward to today. Let’s multiply everything by 8. The same hard-working chap might earn a little over $40,000 a year, but lots of people don’t. That new car that cost $3,000 in 1961 may cost $24,000 today, assuming you can afford one. But that $5,000 policy bought in ‘61 looks pitiful now. It probably wouldn’t satisfy the funeral director.
All of which drives home the point that all fixed-dollar investments are vulnerable to inflation, which is another way of saying, “money don’t buy what it once did.” The bear is eating your groceries you had put back for the winter of your life.
Not so long ago you could shrug and say “well at least my home is growing in value.” In days past, your home was both a physical shelter and a shelter from inflation. Today it’s probably worth less than five years ago. And most of us know what has happened to the stock market. We have been through a “lost decade” in which the S&P 500 is about where it was in 2001, despite the ups and downs.
OK, so where can you hide your money from the horns of the elk and the claws of the bear? In hard times it’s a real comfort to have a fat bank account. That’s a safe refuge, but the bear of inflation is still there. The grim reality is that at three-percent inflation, your dollar will lose one-fourth of its purchasing power over 10 years and almost half in 20 years.
Inflation does the same thing to your life insurance, your bonds, and all other fixed-dollar investments. If you hope to avoid being gored by the elk and eaten by the bear, you have to diversify. By all means, keep a stash of cash in your bank account or your insurance cash value. But to get any growth, you have to venture out and take some risk.
There is one thing, though, that attempts to do both. Take a look at I-Bonds from the U.S. Government. The “I” stands for Inflation, and I-Bonds pay you back with some interest plus the amount of inflation. But don’t get carried away with the idea, because these bonds are long-term investments.
Still, I-bonds are an intriguing thought…that is, if you trust the solvency of the U.S. Government.