What We Should Fear Volume One: Inflation

Photo by: grahammclellan

The economy is always fraught with peril.  Your savings and investments are always subject to risk, and it’s your job to protect them.  Unfortunately, if it were easy to identify the risks out there, we’d do a better job of avoiding them.  One problem that seems to loom in the future of every investment decision is monetary policy.

Depreciation

The current crisis is one of deflation.  People have less money and feel less secure, so they spend less money.  This means that companies have to charge lower prices and make less money, which leads to layoffs, which leads to people having less money and feeling less secure. 1 This cycle is very much like the reverse of the bubbles that we’ve seen in various markets.  The bust is the logical opposite of the boom.

The key difference between the boom and the bust is that the government feels compelled to step in and try to ameliorate the effects of the bust.  They may give lip-service to trying to prevent bubbles, but ultimately their jobs depend on appearing to help “solve” a suffering economy.  Whether or not they can be effective is really beside the point, they have to be seen as “trying.”

The Consequences

The natural upshot of all of this is what is referred to as counter-cyclical policy.  When the private sector is not spending, the government steps up to fill the gap.  Hopefully, the things the government spends its money on providing long term benefits, as well as the short term benefit of creating jobs and demand.  While it may seem like any kind of spending will help break the vicious cycle of depreciation, hopefully you can also reap lasting benefits out of it.  A good example is updating infrastructure like highways or utility grids.  Whether this is the best application is debatable, but ultimately the idea of counter-cyclical spending is a fairly well accepted one.

What this ultimately means however is that in the long term the real threat to your wealth is not the deflation cycle.  In fact the deflation cycle is actually making your savings worth more, while devaluing your assets like your house.  What you ultimately have to fear is the eroding power of inflation. While the government has always sought to keep inflation in check, there are several reasons to think its toolbox will be empty when the time comes.

Inflationary Policy

Anyone who has been paying close attention to government policy recently has seen monetary figures unlike any in recent memory.  The TARP is 700 billion, but represents only a fraction of the money that has already been spent to inject stability and liquidity into the system.  This is before all the counter-cyclical spending that the new administration is planning.  Regardless of the efficacy of these plans, there seems very little to prevent them from happening.  In fact the incoming President has told us to brace for TRILLION dollar deficits for some time to come.2

While the government can posture about how it will cut spending or find other sources for this money, ultimately it will be borrowing it.  It will create a huge debt and will have to escape from it.  The natural escape is through inflationary policy.  By “printing” more money (printing isn’t really necessary anymore, but it’s the same effect), the government will reduce the value of that debt.  This will make it easier to manage, but ultimately will punish those with cash in the bank.

How To Protect Your Cash

TIPS are a very attractive means to protect any savings you currently have.  TIPS, or Treasury Inflation Protected Securities, are like normal Treasury Bonds, but your principal is adjusted for the Consumer Price Index (a measure of inflation).  Obviously you will receive a lower interest rate than you would with normal Treasuries; but if you believe the inflation will exceed that difference, then they are a better deal.  Currently, because of deflationary pressures, this differential is not as great as current spending should suggest.

With the current deflationary effects, and no crystal ball to know where it ends, actually purchasing TIPS can provide you a very safe location for your money.  Not only will they be protected from inflationary pressures, they are guaranteed to retain their value.3 Even if inflation is negative, you will do no worse than your original investment, which means you still will have effectively made money.

For those who are feeling very risk averse and who are concerned about inflation as a result of the current levels of government spending, TIPS provide a safe place to make sure your money is safe.  While they aren’t going to provide fantastic net returns, they are at least going to keep up with inflation, which may not be such a bad deal.

1. NPR – The Economic Battle: Deflation Vs. Inflation [↩]
2. Washington Post – Obama Predicts Years of Deficits Over $1 Trillion [↩]
3. Treasury Direct – Treasury Inflation Protected Securities [↩]

The Best Investment In The World

Photo By: dbking

By this point in people’s lives they are well aware of the merits of 401(k)s and other retirement accounts.  Most people have wisely made them a part of their investment strategy, however many misconceptions still persist about them.  While most people do contribute, many of them spend very little time allocating their funds and instead make other hasty decisions based on misconceptions.  So here are some important things to know about the best investment in the world: tax-deferred retirement accounts.

Always Max Your Match

This advice is usually followed, but there remain people, particularly in this downturn, who have ceased contributions.  If your company matches your contributions at any level, this is one of the most amazing investments available to you.  Many times it may even behoove you to defer paying down debts to maximize your contribution.  While paying a debt may make you 20% tax-free on your money, a 33% match would make you…33%.  This doesn’t even take into account the fact that your contribution is pre-tax, which actually makes it an even more compelling option.  It is almost never a good idea to leave this kind of money on the table, barring extreme circumstances.

Be Aware of Your Options

The most common reason people are breaking the first rule is because of the markets.  Many people have ceased contributing to their retirement accounts because of the insecurity in the stock market.  They are waiting for things to “recover” before they contribute.  There are several problems with this approach, but not the least of which is that almost all retirement accounts have non-stock options.  That means you can usually put your retirement account money into a fund that is not dependent on the stock market.  There are exceptions, and I am not aware of all plans, but why forgo tax-deferment and employer matching when there’s an option to put that money into a secure fund?  It’s simply a question of having your cash in a taxed account or a non-taxed account.

Follow Your Strategy

If you were dollar cost averaging, don’t stop just because the market is down.  That’s the whole point of dollar cost averaging.  Now that prices are lower, you should bring your average cost down quickly if you continue contributing.  I can’t promise you that the markets will resume, but if you ever plan to resume dollar cost averaging, stopping because the market is down is counter-productive.

You also need to be aware of when it’s time to get out of stocks and move to less risky options.  As you get closer to retirement, you no longer have years for things to “average out.”  It’s time to start moving money to safer investments.  Don’t let the lure of additional returns keep you in the market for longer than is safe.  Many baby-boomers are learning that lesson right now.  While 3% may seem unappealing, it’s considerably better than losing money when at the doorway to retirement.

Never let temporary factors cause you to overlook the best investment in the world.  Tax-deferrment has huge implications on your eventual bottom line, so you should be making every effort to maximize your contribution.  Why save 65% of your net when you could save 100%?  And why pay taxes on the earnings of those investments?  You may have more limited options, but they would have to be severely inferior to overcome the huge benefits of preferential tax treatment.

Is It Too Late For An Investing Strategy?

Photo by: pshutterbug

As the savings rate dipped to historic lows, people argued that this was not a cause of concern due to the appreciating value of stocks and real estate.1 People we’re leveraging themselves, but it was considered justified because their houses and stocks were worth more. This of course has proven to be far from guaranteed. People watched as those assets, which were often serving as collateral, spiraled lower and lower in price.

As the markets have plummeted, many people have adopted a “wait and see” strategy. They are “waiting to see the markets recover” before they put any more money into their retirement funds. This begs the question: Why were you investing in the first place?

If these investors thought the Dow Jones was a buy at 14,000, why are they reticent to buy it now at a fraction of that price. Ultimately, the problem is these investors never had a strategy. They’ve only stopped to think about what makes sense investment-wise now that they’ve already experienced large losses.

Is It Too Late?

The simple answer is it’s never too late to have a strategy. However, the strategy you may develop may not paint a rosy picture. Many of us should take this opportunity to do what we should have done before the economic crisis: decide what actions really make sense for us. If you’re hoping to retire in the next few years, should your money be in stocks? Many hopeful retirees’ answer to that question is: I have to leave my money in stocks so I can make back what I’ve lost. My one piece of advice to those who are looking to recover losses in their 401Ks is:

Do not try to “get your money back.”

Until you’ve sold your stock, you haven’t “earned” any of that money. You had an asset that was worth more than when you bought it, and now it’s worth less. That’s the nature of assets. Just because you were up at one point at the casino, that doesn’t mean you get to take home the most you were ever worth while you were there. Ultimately if you had no strategy up until now, there’s no time like the present.

Don’t let the fact that you didn’t develop a strategy earlier keep you from developing one now. Spend some time thinking about 1.) how much money you can expose to risk, and 2.) how soon you’re going to need your money. The right strategy varies from person to person and family to family, and there are countless paths to take. If you want to play “market speculator” and wait for the market to recover, feel free; but understand the risks of this approach. If you want to ignore the stock market that burned you, this may be a valid strategy; but make sure you’re picking the strategy for the right reasons.

Make your strategy now! The next time something like this happens, you’ll be ahead of the game.

1. Wall Street Journal: Don’t Dismiss Our Dismal Savings Rate [↩]