This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Nathan Faber, vice president of investment strategies at Boston-based Newfound Research LLC.
One key issue for investors with a low risk tolerance is inflation. There always comes a point where some risk must be taken to avoid the erosion of purchasing power.
Consider a retired couple who has amassed their target nest egg through prudent saving and disciplined investing. Assume that both partners are 62 years old. According to the IRS, the couple has a joint life expectancy of 29 years.
Unfortunately, inflation will progressively whittle away the value of their cash if they are earning no return. At 2% annual inflation, $1.00 today will only be worth $0.56 in 29 years, a loss in value of 44%.
If we assume the couple plans to spend all of their wealth in equal installments over the 29-year horizon, total purchasing power will take a 23% hit due to inflation.
If we plan more conservatively and use a 37-year horizon, which corresponds to the 95% confidence level of at least one surviving party, then the inflation toll gets even worse. At the same 2% inflation level, $1.00 today will be worth only $0.48 in 37 years. With the longer retirement horizon, total purchasing power is reduced by 28%.
Even if the investors factor this into their distribution calculations for determining their required initial nest egg, inflation is a volatile variable that could throw a wrench in those “no risk” plans. Doing nothing is a choice that still has risk.
Inflation Difficult To Predict
A problem with inflation in planning calculations is that it’s a tricky variable to predict. We can assume an average value, but actual inflation can vary considerably and can be elevated for extended periods.
Data from Federal Reserve Economic Data (FRED). Analysis by Newfound Research. Data from January 1947 to May 2016
The Federal Reserve publishes the quarterly forecasts of the Survey of Professional Forecasters, a group of economists that predict a number of macroeconomic variables. One of the variables they forecast is inflation.
We have shown before that even professional forecasters get things wrong. In fact, the Fed’s own error statistics show root-mean-square errors (essentially like a standard deviation) in the range of 1-2%, depending on how far into the future the forecast looks.
Assuming an expected value for inflation of 2% and normal distribution of inflation rates, we can say we are 95% confident that the inflation rate will fall between about -1% and 5%. That’s quite the spread!
What Investors Can Do
Since forecasting via surveys is an inherently human endeavor, maybe biases can be eliminated by relying on market efficiency.
By subtracting the yield on Treasury inflation-protected securities (TIPS) from the yield on U.S. Treasurys of equal maturity, we can calculate the market expectation for inflation.
Data from Federal Reserve Economic Data (FRED). Analysis by Newfound Research. Data from January 2003 to June 2016.
From this, we get inflation estimates that are based on everyone trading in the market. Surely that must be better than a group of professional forecasters.