Personal finance is rife with rules of thumb. Some of them are helpful, while others are not. Here are some examples:
- Save 15% of your income for retirement.
- Have six months of expenses saved in an emergency fund.
- Put a 20% down payment when you buy a house.
- Subtract your age from 100 to determine the percentage of your investments that should be in stocks.
- Multiply your annual income by 10 to figure out how much life insurance you need.
- You can withdraw 4% of your investment balance per year in retirement and not run out of money.
The great thing about rules of thumb is that they simplify complex ideas. But once a rule of thumb becomes widespread, it tends to be taken as fact. Consider these statements about stocks versus bonds:
- Stocks are riskier than bonds.
- In retirement, you should have more of your money invested in bonds.
Are these statements true? Most people would agree the answer is “yes.” But have you ever explored these for yourself? Are stocks actually riskier than bonds?
What’s the goal of investing?
Most people would say the goal of investing is to make money. I think the answer is more nuanced: The primary purpose of investing is to protect and grow your purchasing power.
Purchasing power is how much goods and services your dollar can buy. Over time, your dollar can purchase less and less because of inflation, the silent killer. You know it’s there, but you don’t notice how it slowly destroys your dollars’ purchasing power.
This is why we invest. If we put our dollars under the mattress, we would still have the same amount of dollars in 30 years. But those dollars have lost purchasing power.
Effects of inflation
Just how bad is inflation’s effect on your dollars? Inflation has averaged 3% over the last 90 years. This means the prices of goods and services have increased by 3% per year. At this rate, $100,000 erodes to $47,761 after just 25 years.
Recently, inflation has been rather tame. In the decade of the 2010’s, inflation only averaged 1.8% per year. But some periods saw much higher inflation. In the 1970’s, inflation averaged 7.4% per year. In 1979, prices rose by 13.3%!
The good news–our wages do a pretty good job of keeping up with inflation. But what about our savings? If you are saving for retirement, or are in retirement, how is your wealth supposed to keep up with inflation?
Stocks vs Inflation
The first way you can grow your purchasing power is by investing in stocks. Stocks are an excellent way to grow your dollars at a rate higher than inflation. Because stocks are ownership in companies, these companies can increase the cost of their goods and services to keep up with higher costs themselves. This means earnings can continue to grow, even after inflation. Since 1926, the S&P 500 has grown at a 10.2% compounded rate.
But what about inflation? If inflation has averaged close to 3%, how does this affect our real return? After accounting for inflation, the S&P 500’s real return since 1926 is 7.1%.
Bonds vs Inflation
The second way you can grow your purchasing power is by investing in bonds. Unlike stocks, bonds aren’t ownership in companies. Instead, bonds are loans that are made to companies or the government. Bonds are known as the “safer” investment. Since 1976, a diversified bond index has only had three years of negative returns.
Investing in bonds has also been profitable. Since 1926, intermediate-term bonds have grown at a 5.1% compounded rate. Not bad for a “safe” investment!
But inflation has its effects. After accounting for inflation, the real return on bonds during this time period was only 2.2%.
Stocks vs Bonds
Looking at nominal (before inflation) returns, stock returns were twice that of bond returns (10.2% vs 5.1%). After accounting for inflation, real stock returns were over three times that of real bond returns (7.1% vs 2.2%). Said another way, stocks were three times better at growing your purchasing power than bonds.
Inflation hits bond investors harder than stock investors. When you buy a bond, the yield is fixed over the life of the bond—it does not increase with inflation. If inflation is higher than your yield, you are likely losing purchasing power. This concept needs to be understood by today’s investors more than ever, as bond yields are at historically low levels.
For example, the Vanguard Total Bond Market ETF has a yield of under 1.5%. If you are investing in bonds with historically low yields, this amplifies the destructive nature of inflation.
What if interest rates stayed put and inflation continued at its historical average? Even though you see a return of 1.5%, the silent killer is decreasing your purchasing power every year.
But what if inflation is more than average? With the amount of government deficit spending and growth in money supply occurring in an economy that is already growing, expectations are that higher inflation is coming.
But aren’t bonds supposed to be safe?
The real risk
If the goal of investing is to protect and grow your purchasing power, we need to rethink our rules of thumb pertaining to stocks and bonds.
Stocks are volatile. Over time, stocks go up in value but are interrupted by periods of stressful bear markets. But volatility isn’t risk. Losing purchasing power is the real risk. Not investing, holding cash, and investing in mostly bonds are all ways to guarantee a loss of purchasing power.
Keeping the same amount of dollars does not mean you end up having the same amount of dollars in the future. Ignoring this fact because you think stocks are too risky does not get rid of it.
Want a new rule of thumb? Avoiding stocks is riskier than owning them.