Still talking about risk (part 2)

In yesterday’s post we described the two primary forms of risk that individual investors face:

1.  The chances of permanent loss of capital, and
2.  The chances of permanent loss of purchasing power

We dealt with permanent losses yesterday. We will turn our focus to the second part of the picture now.  Loss of purchasing power is never as dramatic but it is ultimately a threat to your standard of living every bit as much as a permanent loss of capital.

In planning for retirement three factors are typically considered:

1. How much money are you saving annually?
2. How much are you earning on your savings?
3. How many years are you prepared to save until you get there?

Unfortunately most people overlook the fourth factor: when you do get there, how much is your money going to get you?

We define financial wealth as the purchasing power of our assets or income, and it is a fact of life that the purchasing power of our money loses something each year.  $10,000 used to buy a luxury car, now it would only get you a used Subaru.  We spend more money each year on health, education, housing, food, travel and entertainment.  In some cases, our money gets us more also.  While I don’t think movies are any better than they were 30 years ago, the fact that I can stream them in high-definition on-demand to my home certainly is better!

Inflation destroys the purchasing power of your money over time.  Granted, inflation has been relatively low compared to historic norms over the past several years.  It is not coincidence that interest rates have been low over this period as well, as one usually goes with the other.

Investors who fail to allocate enough of their portfolio to assets that will grow in excess of inflation are dooming themselves to a slow but steady erosion of their wealth.  In almost all cases, this means the allocation of wealth to stocks that are susceptible to wild volatility (again, see yesterday’s post!) but over the long run offer us the only reasonable chance to maintain or grow our purchasing power.

While a balloon bursting certainly will cause a startled reaction, a balloon with a slow leak in it will end up just as flat in the end.