One of the biggest concerns for investors when it comes to long-term investing is the safe return of their capital. Following the 6.75% levy imposed by Cyprus on deposits of less than 100,000 euros, many investors were shocked that such an event could take place.
Certainly, long-term investing does have risks, including a hidden hazard of the possibility that a rising inflation rate will erode wealth just as easily as the levy imposed by Cyprus on bank deposits.
A study done by The Economist showed that people in the U.S. who placed their capital in six-month certificates of deposit (CDs) from 2009 until 2012 earned 3.2% (before tax). Many believe that a CD is among the safest of short-term investments. However, the inflation rate was 6.6% during this time period, resulting in a loss of wealth for the investor of 3.2%. (Source: “The financial-repression levy,” The Economist, March 23, 2013.)
While bank depositors in Cyprus are in an uproar over the one-time levy, American investors have also been hit with a loss of wealth of approximately 3.2% during a three-year period due to inflation, as noted above. Now, imagine the full impact on long-term investing over many years and decades as the inflation rate erodes wealth.
Understanding the real impact of the rate of inflation should alter one’s portfolio allocation when it comes to long-term investing. Simply placing capital in U.S. Treasury notes will not have the rate of return that investors need for retirement.
Many people only look at the nominal return, and not the real return on an investment. Remember, regardless of what the expected return is, for long-term investing, one must exceed the inflation rate to increase portfolio wealth.
There are some who fear that in America cash deposits might be hit by a one-time levy similar to what occurred in Cyprus. These fears are unfounded, and such an event will not occur. However, there are subtle ways of imposing such a levy; for example, through a higher inflation rate. The increased inflation will simply lower the value of future dollars to pay off current debts of the government.
This means that for someone to be successful in long-term investing, one must diversify his or her portfolio away from the standard “safe investments,” such as Treasury bonds. With a higher inflation rate expected, this could result in several outcomes.
One possible outcome is a lower currency. However, with many countries running aggressive monetary policy programs, the net result might be negligible; although this might be true, having a diversified portfolio of investments in various currencies, especially ones that could benefit from higher commodity prices, such as the Canadian dollar, seems like a prudent step. Additionally, some commodities, such as gold, could also act as a hedge against increased inflation and a lower U.S. dollar.
The push to create a higher inflation rate will also mean, by definition, higher asset prices, including stocks, homes, and commodities. However, if the inflation gets too high, then this could hurt these assets, as the central bank would then need to raise interest rates.
There is a fine balance between a high and low inflation rate. Regardless of one’s beliefs regarding the future rate, having a diversified portfolio is crucial. No one can predict the future, and as such, one should have a mix of assets to try and reduce overall portfolio volatility.
When it comes to long-term investing, I believe the worst thing investors can do at this point is not to take into account the potential for a higher inflation rate, and to instead go ahead and buy long-term government bonds. With the tiny interest rate being paid, I believe the future rate of inflation will be higher, resulting in a loss for those investors.
This article Higher Inflation Rate Expected; Long-Term Investors in Danger? was originally published at Investment Contrarians