Purchasing-power risk (also known as inflation risk)
Increases in the cost of living (that is, inflation) can erode the value of your retirement resources and what you can buy with that money — also known as its purchasing power. When Teri retired at the age of 60, she was pleased with her retirement income. She was receiving a $1,600-per-month pension and $2,400 per month from the money that she had invested in long-term bonds. Her monthly expenditures amounted to about $3,000, so she was able to save a little money for an occasional trip.
Fast-forward 15 years. Teri still receives $1,600 per month from her pension, but now she gets only $1,800 per month of investment income, which comes from some certificates of deposit. Teri bailed out of bonds after she lost sleep over the sometimes roller-coaster-like price movements in the bond market. Her monthly expenditures now amount to approximately $4,000, and she uses some of her investment principal (original investment). She’s terrified of outliving her money.
Teri has reason to worry. She has 100 percent of her money invested without protection against increases in the cost of living. (Her Social Security does have inflation adjustments.) Although her income felt comfortable at the beginning of her retirement, it doesn’t work at age 75, and Teri may easily live another 15 or more years.
The erosion of the purchasing power of your investment dollar can, over longer time periods, be as bad as or worse than the effect of a major market crash. Table 2-2 shows the effective loss in purchasing power of your money at various rates of inflation and over differing time periods.
TABLE 2-2 Inflation’s Corrosive Effect on Your Money’s Purchasing Power
| Inflation Rate | 10 Years | 15 Years | 25 Years | 40 Years |
|---|---|---|---|---|
| 2% | –18% | –26% | –39% | –55% |
| 4% | –32% | –44% | –62% | –81% |
| 6% | –44% | –58% | –77% | –90% |
| 8% | –54% | –68% | –85% | –95% |
| 10% | –61% | –76% | –91% | –98% |
A 30-year-old wanting to accumulate $500,000 by age 65 would need to save $440 per month if she earns a 5 percent average annual return, but she needs to save only $170 per month if she earns a 9 percent average return per year. Younger investors need to pay the most attention to the risk of generating low returns, but so should younger senior citizens. At the age of 65, seniors need to recognize that a portion of their assets may not be used for a decade or more from the present.
INFLATION RAGIN’ OUTTA CONTROL
You think 6, 8, or 10 percent annual inflation rates are bad? How would you like to live in a country that experienced that rate of inflation in a day? Too much money in circulation chasing after too few goods causes high rates of inflation.
A government that runs amok with the nation’s currency and money supply usually causes excessive rates of inflation — dubbed hyperinflation. Over the decades and centuries, hyperinflation has wreaked havoc in more than a few countries.
What happened in Germany in the late 1910s and early 1920s demonstrates how bad hyperinflation can get. Consider that during this time period, prices increased nearly one-billionfold! What cost 1 Reichsmark (the German currency in those days) at the beginning of this mess eventually cost nearly 1 billion Reichsmarks. People had to cart around so much currency that at times they needed wheelbarrows to haul it! Ultimately, this inflationary burden was too much for the German society, creating a social climate that fueled the rise of the Nazi party and Adolf Hitler.
During the 1990s, a number of countries, especially many that made up the former USSR and others such as Brazil and Lithuania, got themselves into a hyperinflationary mess with inflation rates of several hundred percent per year. In the mid-1980s, Bolivia’s yearly inflation rate exceeded 10,000 percent.
Governments often try to slap on price controls to prevent runaway inflation (President Richard Nixon did this in the United States in the early 1970s), but the underground economy, known as the black market, usually prevails.
Career risk
If you don’t continually invest in your education, you risk losing your competitive edge. Your skills and perspectives can become dated and obsolete. Although that doesn’t mean you should work 80 hours a week and never do anything fun, it does mean that part of your “work” time should involve upgrading your skills.
The best organizations are those that recognize the need for continual knowledge and invest in their workforce through training and career development. Just remember to consider your own career objectives, which may not be the same as your company’s.
Analyzing Returns
When you choose investments, you have the potential to make money in a variety of ways. Each type of investment has its own mix of associated risks that you take when you part with your investment dollar and, likewise, offers a different potential rate of return. In the following sections, I cover the returns you can expect with each of the common investing avenues. But first, I walk you through the components of calculating the total return on an investment.
The components of total return
To figure out exactly how much money you’ve made (or lost) on your investment, you need to calculate the total return. To come up with this figure, you need to determine how much money you originally invested