One really rewarding part of the investment business is working with people on their financial plans and one of the interesting challenges in this process is predicting future inflation rates. Specifically, I am often asked something like this: "How much inflation should I assume when planning for retirement?"

This seems like a simple question. But if you look into it seriously, it opens up a can of worms and introduces a subject that most people don't want to talk or think about. Therefore, the following discussion may not be to everybody's liking.

Inflation is a silent but deadly process that attacks even the very best investments and financial plans. Yet many financial advisors essentially throw up their hands when asked to predict inflation. One common response is to adopt a very thoughtful posture (hopefully suggesting great wisdom) and suggest to a client that inflation "probably" will remain in the 3 to 5 percent range in the near future. Many advisors throw the question-and the risk that follows from any answer- back to the client. Often the client is told to name a figure for assumed inflation, and that figure is then entered into a computer model that can affect the other calculations that make up a financial plan.

In the short term, there are few good alternatives to simply picking a number that seems reasonable. But in the very long term, any number we pick is likely to be meaningless.

THE RASCAL IN ROME

Here's the story of an ancient Roman rascal entrusted with a large sum of money to establish a trust fund to run for 2,000 years. This rogue pocketed all the money except a single penny, which he invested in Roman government bonds paying 3 percent compounded annually. He didn't live long enough to see the results, but after 2,000 years that penny wound up being worth more than all the assets on the Earth. That is the magic-or perhaps the fraud-of compound interest calculations extrapolated over very long periods of time.

In reality, nothing that was worth a penny back in Roman times ever grew to be worth all the assets on Earth now. Why?

Once, it seemed true that "All roads lead to Rome." But the government of Rome eventually declined in military, political and economic strength. In the 19th century, "The sun never set on the British Empire." But those days are now just a memory. The 20th century has certainly been "prime time" for the United States, which in the last few years has emerged as the world's only remaining superpower. For now, the U.S. government's guarantee is regarded as rock-solid, and probably is as good as investors will find anywhere.

However, change is one of the few things humans can count on. And anybody who expects the status quo to remain constant for a long period of time is simply ignoring history. That is why I am wary of the easy assumption about inflation continuing at 3 to 5 percent into the knowable future. Although I expect that level of inflation during my lifetime, a rate this high has never been sustained for very long periods of time.

ALL THIS FOR A STICK OF GUM!

This is a long-winded introduction to one of my favorite topics, the price of a stick of gum. An 11-year-old girl was in my office recently and I asked her if she could still buy a stick of gum for a penny. She looked at me as if I were a visitor from another planet and told me a stick of gum costs a nickel!

To me, a stick of gum "really" should sell for a penny. And this girl probably will live her life believing that the "true" price of a stick of gum is 5 cents. But if you believe inflation will continue as it has in recent years, this girl may find out in another 40 years that a stick of gum costs a quarter, not a nickel. It's all relative, and perhaps the minimum wage in 40 years from now will be $25 an hour, and a cheeseburger, fries and a milkshake will cost $21.

If your time horizon is only 40 to 50 years, these assumptions about inflation seem to make sense. But if the assumptions are really valid, we should be able to extrapolate them to longer time periods. So let's indulge in a little math, assuming "mild" inflation of 3 percent, a rate we have come to accept as somewhere near "normal."

At 3 percent, today's 5-cent stick of gum in 50 years should cost 22 cents. That's within the range of reality for most of us. After 100 years, that stick of gum would cost 96 cents, a price that starts to stretch the imagination. By that same measure, a luxury car that costs $52,000 today would cost $1 million in the year 2094 (and you don't even want to think about the monthly payments).

$340 BILLION FOR A PIECE OF GUM

If we follow the life of that 5-cent stick of gum further into the future at 3 percent inflation, it's worth $18 in 200 years. In 600 years, a child would have to carry nearly $2.5 million to the corner store to get a stick of gum. The price would rise to about $340 billion in 1,000 years, and most of today's calculators could not even display the price 2,000 years from now. Assuming a 3% inflation rate, a piece of gum now costing 5 cents will sell for $24 billion trillion or $2,400,000,000,000,000,000,000,000!

Obviously, we are being absurd. But if 3 percent inflation is "normal" for now, yet impossible to sustain over long periods of time, something will have to interrupt "normal" inflation. And personally, I believe that will happen. History is filled with major adjustments, some sudden and some gradual. Some have been natural and many were man-made. But they all disrupted and often destroyed what had seemed to be a steady course of life that people could count on.

Just as stock market corrections periodically wring out excessive optimism, major catastrophes seem to occur frequently through the centuries to pull the rug out from under what we think is secure and predictable. In this century we have had two great world wars, persistent famines and major political upheavals in much of the world.

WAS CHICKEN LITTLE RIGHT?

If we assume a major financial collapse once every 100 years, that gives you 1-in-100 odds that it will happen in the next year. That seems pretty remote, but how about 2 to 1 odds for a collapse during the next 50 years, 4 to 1 odds for the next 25 years or 10 to 1 odds for the collapse to happen in the next 10 years? Longer life expectancies, like those of my grandchildren Aaron, Sara and Krista, seem to increase the odds that they could experience some extremely traumatic times. This is a particularly uncomfortable thought, and it reminds me of why I am so adamant about handling my money and my clients' money in a way designed to minimize their exposure to catastrophes.

CAUGHT BETWEEN PATIENCE AND PANIC

Our strategy is to take decisive action when things start to turn sour. When markets start going down, our timing systems get us out of those markets. We don't simply reduce our positions. We get out. Buy-and-hold investors, on the other hand, are left to twist in the wind, caught somewhere between patience and panic until there are no options left to shield them from the full impact of a market setback. I am not a prophet of gloom and doom, though perhaps I could make big money giving "scare" seminars and writing books about "inevitable" market collapses that are "just around the corner." Sorry, but that's not my cup of tea.

MY TWO ASSUMPTIONS

However, I base my work and my investment strategy on two assumptions, neither one guaranteed. Investors who follow our timing systems and recommendations need to understand them. My first assumption is that we will get out of a declining market somewhere reasonably close to the top. We may not get out on the first day of a big downturn. But with any luck we'll be out well before the biggest hits (which is what happened in 1987 and 1990). My second assumption is that money market funds will provide a safe haven for money that has left the markets.

The Great Depression of the 1930s was an awful time for many people, especially buy-and-hold investors. But its legacy still holds lessons for us today. Starting in 1929, the stock market lost 85 percent of its value in about three years. We, of course, were not doing market-timing then, but our trend-following systems would have had us completely out of the market by September or October 1929.

Investors who followed our timing systems would not have escaped all the damage. But they would have recovered much better than their buy-and-hold brethren. By the end of 1932, few investors had much money left, and we don't often hear about the stock market's performance over the next four years. But for those who could take advantage of it, 1933 was a blockbuster year, with the market up 54 percent. Though the S&P 500 Index dropped 1.5 percent in 1934, that was followed by big back-to-back gains of 48 percent in 1935 and 34 percent in 1936. That means that $10,000 invested at the start of 1933 more than tripled to $30,083 in four years-a major bull market right in the heart of the Great Depression.

Investors who had followed a system such as ours would have been able to take advantage of a portion of that bull market. But even after these excellent market years, those who "rode it out" since 1929 would have had less money at the end of 1936 than they had before the 1929 crash.

Obviously during really severe market downturns, investors are much better off if they follow a defensive strategy. Unfortunately, crashes rarely advertise themselves in advance, and those who wait until the need for timing is obvious are already too late. They have missed the boat. That's why I strongly advocate market-timing as a permanent, steady discipline.

ARE MONEY MARKET FUNDS SAFE?

In the 1930s, cash was king. Money market funds did not exist then, and they have never been tested in a major depression. Almost all the investments in money funds are high-grade securities, either government or corporate. In the 1930s, there was nothing comparable to today's short-term commercial paper market, only an informal network of trust that existed between the heads of major corporations. Many met their obligations, but many others defaulted.

I think it is obvious that many corporations could be seriously hurt in a severe economic crisis, and the viability of their commercial paper is uncertain. Even though money funds are not guaranteed, I believe they are the prudent investor's first line of defense. Money-fund investors can get a higher level of protection by sticking to funds that invest only in U.S. government obligations.

Insured savings accounts may be slightly safer than government money funds because they have the government's direct backing. However, most other defensive investments are awkward and illiquid: gold, other metals and commodities, real estate and perhaps foreign currencies. In summary, I've never found an investment that I would describe as perfect. But among the alternatives available today, I think money market funds offer the best combination of reliability and convenience as a defensive position during declining stock or bond markets.

BACK TO THE FUTURE

Now let's return to the original question: How much inflation should an investor plan on for the future? I say there is no way to know the "right" answer. For now, 3 to 5 percent seems reasonable in the United States. In many countries, inflation is much higher than that, in some cases routinely exceeding 25 percent a year. However, history strongly suggests that a major setback of some sort will hit someday, quite possibly when we are least expecting it. For myself and my clients, I believe the best protection against such a setback is the combination of market-timing and money market funds. I hope you have adopted this strategy, too.

 

 

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