The death of Chaim’s father was a classic tragedy and windfall combination. Chaim, the only heir, was now coming into a $1 million yerusha, proceeds from the sale of his parents’ home. The money would make a huge change to his growing families’ financial situation. While it was challenging for Mrs. Frisch, a mother of six, to juggle work and home, until now they had needed the $25,000 her full-time work brought in. By investing the $1 million, they could permanently replace Mrs. Frisch’s salary allowing her to stop working. Instead of risking this money in the stock market or real estate, Chaim planned to place all the money into super-safe government bonds which would produce $25,000 annually (2.5%). The most important thing to them was a guaranteed income, not maximum growth.
What is the hidden risk which may ruin Mr. Frisch’s plan? Why will he lose money despite being invested in bonds guaranteed by the US Government?
Inflation: A Silent But Significant Risk
Humans are often fearful of dramatic immediate dangers while ignoring common but hidden long-term risks. For example, most people don’t give much thought to pounding their arteries with vast amounts of deli meats and kishke even though 25% of deaths are from heart disease. Similarly, Chaim’s investment plan ignores the danger of inflation which is much more damaging over the long run than he realizes. By avoiding the volatility of stocks or real estate, Chaim is protected from a sudden dramatic collapse in value, but his “safe” bond investments will be destroyed over time by quiet but steady monetary inflation.
Inflation Destroys Your Money’s Value
Although the Frisch’s $25,000 in annual bond income is guaranteed, because of inflation, that money will buy fewer goods each year. When money loses its value ( or its “purchasing power”), it has been inflated (as in a balloon full of empty air). Inflation is the reason why the loaf of bread which cost your Grandfather a quarter and your Father a $1, sets you back by $2.50: nothing changed except the value of the currency. Long-term inflation has been about 3% in the United States: at that rate the Frisch’s $25,000 of investment income will be worth just $18,435 after 10 years (in today’s dollars), $13,594 after twenty years and only $10,025 after 30 years of inflation… a virtually guaranteed 50% loss of purchase power! This potential for inflation loss is why professional investors consider bonds, which cannot grow as well as stocks or real estate, very risky for long-term needs.
The Devastation of Runaway Inflation
With 3% inflation, it would take 30 years for Chaim to lose 50% of his real buying power. Sometimes, however, inflation spirals out of control and devastates the currency much more quickly. Extreme examples of hyperinflation, such as Venezuela’s currency recently falling by 50% in one month (!), are usually reserved for failing countries. But not too long ago, even the United States, went through a period of runaway inflation. In the 1970’s inflation averaged 7.25% annually which equals a 53% loss of purchasing power in just ten years! This terrible result is a far more significant loss than any 10-year period of the stock market’s history including the during the Great Depression. Although the stock market is hazardous in the short term, Chaim’s strategy of leaving money with no long-term inflation protection is a very dangerous strategy!
Real Returns Are What Really Count
Inflation losses don’t show up on your bank statement, and a $100 bill looked the same in 1980 as it did ten years earlier even though it could buy less than half as much bread. But inflation losses are real and knowledgeable investors calculate inflation-adjusted returns (known as the real return) as well as the pre-inflation profits (called the nominal return). For example, bonds paid significantly more interest in the 1970’s than today, averaging 6.27% annually (nominal) vs. recent bond returns of 4.18% (nominal). However, due to much higher inflation, the 1970’s real bond returns were much worse equaling -1.01% annual (real) vs. the past decades’ 2.33% (real)…. more than 3% higher on an inflation-adjusted basis. Calculated as real returns, Chaim will be earning -.5% at best (2.5% interest –3% inflation), and as he draws money out, his $1 million pot will become less and less valuable (plus the fact that his $25,000 income will buy less goods each year).
Diversifying All Over the Field
Investment diversification is about playing defensively for a variety of relevant risks. Imagine a baseball team captain who puts all his defensive players in just one part of the field. By over-protecting one spot, the team is vulnerable elsewhere and will almost definitely lose the game. Similarly, Chaim is so focused on protecting himself from the downturns of stocks and real estate, that he is leaving himself undefended from the long-term effects of inflation. By putting a significant chunk of the $1 million inheritance into stocks and real estate, which have much better inflation protection, the Gruss’ will have higher chances of winning the investment game.
Just By The Way: The Inflation Shaila Asked To R Moshe Ztl
Inflation has been around for as long as there has been money and numerous shailos arise from it. Is it Ribbis to charge interest just to cover any inflation? There is no “real” profit to the lender but the amount paid back is nominally larger than the loan. Another interesting shaila is “do you pay Maiser on investment profits on a nominal or real basis? R Moshe Feinstein Ztl received this question in the 1970s which as mentioned had very high inflation. The investor had bought real estate for $100,000 and sold it for $200,000, but because of inflation the $200,000 could only buy the equivalent of $120,000 at the time of the investment. On a nominal basis the profit was 100% ($100,000 + $100,000) and the maiser would be $10,000 (10% of the $100,000 in the nominal profits) but on a real basis the profit was just 20% ($100,000 + $20,000) and the maiser would be just $2,000 (10% of the $20,000 in real profits). I’ll leave you in suspense-ask your LOR what to do lmaiseh, but clearly, inflation is a “real” problem.