If you're now living on $2,500 a month, how much will you need to live the same way 20 years from now if annual inflation is 5.5% during the next two decades?
Answer: $7,295 a month.
While inflation no longer is raging the way it was a few years ago, it's clearly above last year's low rate of 1.1%. But, "no need to panic," many experts say; "there's scant danger of another double-digit inflation horror show." They expect that the consumer price index will rise only 4% to 6% this year.
Do these experts understand what havoc a 4% or 6% inflation rate can play with your personal financial planning? Probably not.
Ado About Nothing
And the danger is that unless those kinds of figures are better understood, you might be lulled into believing that this year's inflation is much ado about nothing.
Instead of dropping your guard, you should be careful to protect yourself financially by keeping the value of your assets growing faster than inflation.
Even in the 1930s, when inflation was not a topic of daily conversation, it still presented serious problems. Anyone of the right age and with a certain sense of humor can chuckle at the 1935 magazine advertisements by an insurance company specializing in annuities.
The ads showed a youthful-looking, gray-haired couple and carried a headline that read: "How We Retired on $150 a Month." Four years later, a new headline said $200 a month. The best overall defense against inflation is diversification. If you diversify, the value of some of your assets should rise when economic conditions reduce the value of your other holdings.
During the past two decades, diversified investment portfolios--as gauged by an index put together by the investment advisory firm of Bailard, Biehl & Kaiser--have outpaced the U.S. stock market and the performance of the typical portfolio manager. And diversified investments, as well as the stock market, historically have outperformed inflation.
The Bailard, Biehl & Kaiser index consists of five equally weighted parts: U.S. stocks, foreign stocks, U.S. corporate and government bonds, real estate and Treasury bills. It has grown at a 10.2% annual compound rate since 1965, compared to 9.4% for Standard & Poor's 500-stock index.
During the same period, the median U.S. money manager who invested in both stocks and bonds had an annual return of 7.9%, according to SEI Corp.
Most of the extra gains came from foreign stocks, which today have grown even stronger, and real estate, which raced ahead of U.S. stocks for much of the 1970s and generally continues to keep up in the 1980s. But you don't own the index, so how can you best design your personal portfolio?
To begin with, you should consider the investment objectives of hedging, growth and income. The amount of money devoted to each category will depend upon your overall goals, current investment position and investment attitudes.
Also, all investors should have some portion of their investments in money-market funds or similar accounts, both to keep a portfolio flexible and to handle emergencies. Usually three to six months gross income is a proper amount.
The hedge portion: Hedging is a strategy used to offset investment risk. It might include either gold and silver coins or a precious metals mutual fund.
This is especially helpful for retirees, and those expecting to retire in the next few years, because, unlike younger investors, they cannot expect to see their income keep up with high future inflation. Precious metals protect older investors because these investments tend to do well during difficult economic times or when such times are expected.
As a general rule, I recommend that people over age 60 put 10% of their investment portfolios in precious metals. Investors from age 30 to 60 should have between 3% and 10% of their assets in precious metals, depending on how much they can afford to tie up that way.
The investment portion: One or more investment vehicles should be used to provide a combination of regular income, plus the reasonable expectation of appreciation.
For regular income, you should consider everything from passbook savings accounts to certificates of deposit, from Ginnie Mae mutual funds to five-year Treasury notes, from single-premium insurance to universal life insurance.
Investments that can provide a combination of income plus the reasonable expectation of appreciation include: real estate holdings carrying little or no debt, convertible bonds or convertible bond mutual funds, medium- to high-dividend domestic stocks or mutual funds that concentrate their holdings in these types of stocks, high-dividend international mutual funds and variable-rate insurance products.
Generally, the majority of your holdings will fall into the investment category. But diversification for many of you can also include an opportunity for appreciation without income.
Some of the investment alternatives in this category are resort property, raw land, art, antiques, coins, stamps and other collectibles, as well as growth stocks or growth-stock mutual funds, domestic or foreign. Such investments, which don't pay dividends or interest, generally respond well to inflation but are more suited to people willing to take greater risks and who have a number of years before they plan to retire.
The bottom line: During the years ahead, you must make every effort to manage your investments. Through intelligent diversification, you should gain the higher margin of safety that is so necessary in today's inflationary climate. You will also be ready if inflation someday is only 10%.