Fifth-Grade Math

In the MarketMinder column, "A Sham for the Ages," we talked about why an aged-based approach to asset allocation doesn't hold water. Simply subtract your age from 100, and that's the percentage you should have in stocks. Simple…metric…brilliant! But wrong.

This old investing rule of thumb is perhaps why investors in or near retirement often assume it's prudent to shift heavily, if not exclusively, to a portfolio consisting of bonds. After all, bonds provide a "safe, secure" income stream. What's more, even if the principal value of your bonds falls, you can simply hold them until maturity and get your money back. Makes sense, right? Wrong again.

There's a tendency for people to think of their wealth in terms of the number of actual dollars they own, as opposed to their level of purchasing power. This concept, called the "money illusion," was first observed by economist John Maynard Keynes. In an economy where inflation is present, relying on a buy-and-hold approach to fixed income virtually guarantees a loss of wealth in real (inflation-adjusted) terms.

Inflation decreases purchasing power over time and erodes real savings and investment returns. A primary measurement for the rate of inflation in the US is the Consumer Price Index (CPI), which tracks the average aggregate change in the prices of goods and services purchased by retail consumers. CPI figures are prepared and reported monthly by the Bureau of Labor Statistics and include everything from housing costs to supermarket trips, your annual doctor's checkup bill, and your grandkids' overpriced new sneakers.

CPI has averaged approximately 3.17% annually since 1926.* Over the last 20 years, the slowest rising prices have been in consumer durable goods (things like computers and televisions) and apparel (except those overpriced new sneakers that come with the latest celebrity-athlete endorsements).

On the other hand, service-related industries in the US have inflated at higher-than-average rates. The largest gain over the last 20 years? College tuition and fees. The cost of obtaining a diploma has outpaced average CPI three-fold over that time-frame and shows no signs of slowing. Closer to home for most retirees, the cost of hospital services, prescription drugs, and physician's services all have appreciated at rates much faster than the average CPI over the last 20 years. Like education costs, these expenses continue to grow faster than average, with no signs of abating.

Inflation can be especially harmful to a buy-and-hold approach to fixed income. Many investors buy fixed-income securities to generate stable income in the form of interest (or coupon) payments. However, because the interest on most fixed-income securities never changes, the purchasing power of the interest payments declines with inflation. Said differently, your income stream is worth less and less each year with rising inflation. This is especially dangerous for retirees who face increasing medical needs and costs.

Rising inflation also erodes the principal value of fixed-income securities. That means when an investor "gets their million dollars back," it won't buy $1 million worth of goods and services in inflation-adjusted terms. If an investor buys 10-year bonds with principal values of $1 million and the rate of inflation is 3.17% annually, the purchasing power of the principal, adjusted for inflation, will sink to about $732,000 over the 10-year term of the bond. Stretch that over 30 years, and you're left with about $392,000 in today's dollars.

It's not that fixed income is always bad. Depending on time horizon, cash flow needs, and return expectations, some investors should have some bonds in their portfolios (though often less than they might think). There are even bonds whose interest and/or principle value adjust with inflation (such as TIPS). Most importantly, if bonds are appropriate for you, an actively managed bond portfolio that seeks total return is preferable to a passive fixed income investment approach.

Subtracting your age from 100 is so easy an elementary school student could do it. But before you enlist the math skills of your fifth-grade grandchildren for asset allocation advice, think about protecting yourself from the risk of inflation eroding your portfolio over time. Who knows, you might just have some left over to buy them a new pair of overpriced sneakers.

*Ibbotson Associates