Articles

Finding Beauty Within The Inflationary Beast

By Daniel R. Amerman, CFA

Take A Walkabout Into Your Future, In The Shoes Of The Person Buying Your Investments....

In this article we will meet a ravenous Beast that goes by the name of Substantial Inflation, and find out just how difficult it is to keep this Beast from shredding our investment portfolios and consuming our real net worth.  Next, we’re going to find out how the exact same inflationary conditions which create the Beast, also simultaneously and necessarily create a ravishing Beauty.  An easily available Beauty with a most desirable figure, for she generates after-tax and after-inflation benefits that are equivalent to a conventional investment earning 27% per year.  As we continue to mangle our fairy tale metaphors, we will find out what happens when Beauty pairs up with a Golden Prince, and how our portfolios can live happily ever after.

Let’s start with theBeast, and a question – what if real inflation is 10% or more?  Some people might say this is a very good question for the next several years, when we look at such issues as the budget and trade deficits, or paying for promises made to Boomers.  Other people (such as John Williams of Shadowstats.com) might say it is a good question for today, when we take into account real price changes in such categories as energy, food and health care.  There are numerous discussions of the reasons to fear inflation elsewhere, in this article we will instead take some quick looks at possible solutions.

The Ravaging Beast: 

10% / (100% – 40%) = 16.7%

The simple equation above is a picture of the Beast, and it is an ugly Beast indeed.  The equation calculates the investment return we have to earn in order to merely stay even with inflation.  Not really make any money, just run in place and keep our wealth worth the same in inflation-adjusted terms.  The simplest way to view this return is to say that if the value of our money declines 10% each year because of inflation, then we must earn 10% per year just to keep up.  Unfortunately, in today’s investment environment there are no widely available ways to earn anything close to a ten percent risk-free yield.

The full situation is much worse.  Because the relationship between inflation and taxation is one of the more unfair aspects of life.  Government policies create inflation.  That inflation creates the illusion of income.  The illusion of income is then fully taxed by the government.  So our illusory 10% yield, that is really just keeping pace with inflation, is taxed by the government with most forms of investments.  If our combined state and federal marginal tax bracket is 40%, then we lose 4% of our yield, meaning our after-tax yield is only 6%.  So even an investment yielding 10%, in an environment of 10% inflation, would only be locking in a 4% annual loss in real purchasing power terms.

This brings us back to our Beast equation above.  To stay even with 10% inflation, we have to earn an after-tax yield of 10 percent.  So we divide inflation by one minus our marginal tax rate, and find that it takes a 16.7% rate of return to stay even with 10% inflation.  As an example, if we invest $100,000, then we lose $10,000 (which is 10%) of the real value of the principal amount of our investment to inflation the first year.  We must earn $16,700 in income, which is taxed at a rate of 40%, meaning taxes take $6,700 of our earning.  Ten thousand dollars of lost purchasing power, plus $16,700 in nominal income, less $6,700 in taxes all add up to zero, meaning we truly do have earn almost 17% to just tread water and maintain the purchasing power of our savings!

Where, exactly, do you invest today to earn a 17% rate of return?  With dividend ratios below 2%, and ten-year US Treasury bond rates below 5%?  Inflation truly is a Beast, particularly when in markets where inflation is not priced into the yield levels, as is the current case. 

A Tantalizing Beauty: 

[-6.5% X (100% – 40%)] + 10% = 6.1%

To uncover the alluring Beauty that can be found within the inflationary Beast, let’s put some numbers to the equation above. 

(The rest of this article is available as part of the free Mini-Course, "Turning Inflation Into Wealth".  The article has been placed in context as part of a series of ten to fifteen minute readings that will cumulatively build your understanding, in an educational process that will lead you towards uncovering new opportunities for personal actions and profits.  More information on the free course can be found here.)

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