The frum community tends to embrace the risk required for growth investing. Whether due to bitachon, the need for big bucks, or watching others around them strike it rich, most have no problem putting their money in harm’s way in the hopes of significant profits. Risk tolerance, within reason, is a good thing. But some are afraid to move money out of the bank. While I’m sympathetic to this cautious approach, they’re often missing the boat.
Imagine a successful business owner, or a family that comes into a yerusha, has $1 million to invest. Out of a desire to protect the principle, they put all of it into super-safe government bonds paying 4% annually. The $40,000 guaranteed passive income interest may be tempting to the risk-averse. However, ignoring inflation is a hazardous approach to money.
Inflation: A Silent But Significant Risk
It is all too human to be 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 goulash and kishke, even though 25% of deaths are from heart disease. Similarly, an investment plan based on bonds ignores the danger of inflation, which is much more damaging in the long run than most realize.
By avoiding the volatility of stocks or real estate, investors may be protected from a sudden dramatic collapse in value that may be nerve-shattering for a couple of months or even a couple of years. In contrast, they might sleep like a baby through decades of “safe” bond investments whose value will be irrecoverably destroyed over time by quiet but steady monetary inflation.
Inflation Destroys Your Money’s Value
Although income from a bank CD or government bond is guaranteed, that money will buy fewer goods each year because of inflation. When money loses its value (or its “purchasing power”), it has been inflated (as in a balloon full of empty air). Inflation is why the loaf of bread, which cost your grandfather a quarter and your father a dollar, sets you back by $4.50. Nothing changed except the currency’s value.
Long-term inflation has been about 3% in the United States. At that rate, $40,000 of guaranteed bond investment income will be worth just $29,497 after 10 years (in today’s dollars), $21,752 after twenty years, and only $16,040 after 30 years of inflation… A virtually guaranteed 60% loss of purchasing power! This potential for inflation loss is why professional investors consider bonds, which cannot grow as well as stocks or real estate, very risky over the long term.
The Devastation of Runaway Inflation
With 3% inflation, it would take 30 years to lose 60% of your 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 having fallen 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.
Throughout the 1970s, 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 during the Great Depression. Although the stock market is hazardous in the short term, a strategy of leaving money with no long-term inflation protection may permanently impair your portfolio!
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. However, inflation losses are real, and knowledgeable investors calculate inflation-adjusted returns (known as the “real” return) as well as pre-inflation profits (called the nominal return). For example, bonds paid significantly more interest in the 1970s than today, averaging 6.27% annually (nominal) vs. recent bond returns of 4.18% (nominal).
However, due to much higher inflation, 1970s real bond returns were much worse, equaling -1.01% annual (real) vs. the prior decade’s 2.33% (real) return, more than 3% higher on an inflation-adjusted basis. Calculated as real returns, the aforementioned frum family coming into a $1 million yerusha would be earning 1% real return at best (4% interest –3% inflation), and as they drew out the full 4% annually, their $1 million pot would become less and less valuable (plus the fact that their $40,000 bond income would buy fewer 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, a family so focused on protecting themselves from the downturns of stocks and real estate leaves themselves undefended from the long-term effects of inflation. By diversifying a significant chunk of the $1 million inheritance into stocks and real estate, which have much better inflation protection, they will have higher chances of winning the investment game.
Just By The Way: The Inflation Shaila Asked To R’ Moshe Zt”l
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: Do you pay ma’aser on investment profits on a nominal or real basis? R’ Moshe Feinstein zt”l received this second question in the 1970s which, as mentioned, was marked by 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 ma’aser 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 ma’aser 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 l’maiseh, but clearly, inflation is a “real” problem.
(Also, check out this article by Rabbi Baruch Fried Shlita, Dayan Bais Haavvad, my very chashuve brother, Is Ma’aser Given From Gross or Net Income.)
Investing for Inflation Protection.
As Washington, DC, both Republican and Democrat, continue adding massive deficit spending, inflation risk remains exceptionally high. In this article, I examine how different investments performed during the stagflationary 1970s and 1980s. We review clear data on how stocks, bonds, real estate, cash, gold, and commodities performed. On a most tachlis level, the article demonstrates how a fully diversified portfolio incorporating all these investment building blocks did surprisingly well through a volatile inflationary time. Economic history may well be repeating itself, so check it out!