Inflation since 2008 has been very low. The average since 2008 is a paltry 1.48%. The numbers annually are as follows:
Year Rate of inflation
This is very good news for Retirees. This article will focus on some reasons many don’t think about.
I would like to introduce the term Real Return. Real return is gross return less inflation. Financial planners pay particular attention to Real Return. Planners need to compare investment returns over long periods of time. Inflation impacts not only prices but also investment returns.
Retirees and investors often inquire about how their money is doing. They want to know their investment return over a particular year. While this may seem like good information it does not tell the whole story. Let’s look at an example. Suppose we choose 1979 and we were 100% invested in the S&P 500, a broad basket of US large company stocks. At the end of the year we are thrilled because our investment was up 18.52%. However, if we looked at the rate of inflation we would find some news that was not so good, inflation was 11.3%. The Real Return would be the difference between the two. Gross return of 18.52 minus 11.3 equals 7.22%. The 7.22% Real Return is not an exceptional result. For the most part it would be considered an expected return, assuming assets were 100% invested in stocks.
When investors put money in stocks they take risk. The expectation is that for this additional risk there should be a return. This is referred to a risk premium. Thus stocks have historically outpaced inflation over the long run by 6-8% per year.
Theoretically, higher inflation means higher return in stocks. Lower inflation means lower returns on stocks.
Since the new millennium US stock returns have been well below average. The results show the S&P 500 averaged 5.71% per year since 2000 (inflation has averaged 2.1% during this timeframe). Historically the SP 500 has averaged just under 10% dating back to the 1920’s. Additionally, most know interest rates have been very low for a long time. This impacts returns on bonds and money markets making them historically low. Since most retirees have significant exposure to stock, bonds and cash overall returns have been subpar.
Seeing low performance on investment statements creates anxiety and worry for those trying to live off their nest egg. Much has been written about low returns in the media this adds fuel to peoples fear. Fortunately not all the news is bad.
We now come full cycle to the title of our piece “Now the Good News.” If we look at Real Return, the numbers may not be as bad as they have been reported. Low inflation helps this calculation. Low return, minus low inflation, equals real return that is not too bad.
You should create a financial plan where you calculate real return. You may just find a silver lining, allowing you to live happily ever after. You cannot simply ask what the return was that I earned with my money.
If you don’t have a financial plan that measures Real Return, you should get one.