Imagine having to save, dollar for dollar, what you need in retirement. Now add in inflation. Your dollars need to keep up with the rising prices of all that stuff you’ll want and need in retirement. You’d have to out save that anchor slowly dragging down your dollar’s purchasing power.
This is why you invest.
Your money must keep up with the rising cost of inflation. In truth, inflation is what you’re really trying to beat when you invest.
Saving money is the first step in everyone’s process. Step two is to protect your savings from, and grow it faster than, inflation because your savings goes further when you do.
And you need to outpace inflation without taking on unnecessary risks. Your success determines how much, or how little, you need to save. In other words, any shortfall needs to be made up with more savings.
Lucky for you there’s one asset class that does particularly well against inflation. Stocks. No other asset class comes close.
|Asset*||Nominal Returns||Real Returns|
*U.S. stocks represented by S&P 500 returns since ’26, international stocks by MSCI EAFE since ’70, emerging markets by MSCI EM since ’88, and government bonds by 10-year Treasuries since ’28.
Stocks produce about twice the return of bonds. Now compare stock returns to bonds when you take out inflation, as seen by the real returns. Inflation, measured by the CPI, averages about 3% historically. After inflation, stocks outpace inflation two to one, and produce about three times the return of bonds.
Comparing the two, bonds do a decent job of maintaining purchasing power over time. But a 2% real return doesn’t leave much room for error once you consider taxes and a higher risk of inflation spikes. During periods of rising inflation, the borrower benefits most. And since nobody knows where inflation will be in the future, stocks offer the best long term protection from that uncertainty.
Simply, bonds aren’t built to grow money. Though, it will help take the sting out of volatility.
That volatility is the trade off you get for the higher returns of stocks. These temporary market swings are a part of investing, but how you react to it will define your chances of beating inflation. In other words, your results may vary.
Volatility pushes investors to do things they shouldn’t do, like confuse a short term market drop with a long term problem or think another asset class, like bonds, is far superior when history says otherwise. It leads to bad decisions, higher costs, lower returns, and a shortfall that needs to be made up somewhere – like out of your pocket.
When you shrink your time horizon from decades to days, its easy to confuse volatility for something it’s not. It becomes the boogeyman under the bed. Volatility is a temporary short lived fear built up in our head. The idea of it seems scary at the time, but when you look back on it years later, you realize how foolish it was.
Historically, U.S. stocks finish positive for the year about 80% of the time. You’ll find similar results for international and emerging markets stocks. Looked at another way, stocks end up higher four out of every five years. If we stop focusing on the next day, next month, or even next year, we start to see what’s possible twenty years from now.
Now, if you try to beat inflation over a year or two, there are better investments available because stocks don’t always play nice in the short term.
But when you have retirement savings that won’t be used for decades, stocks should be the driving force behind your portfolio. Your savings go further when you outperform inflation. Passing up that potential growth adds another risk – of missing your goals.