Improving Investor Behavior: Overcoming inflation using a familiar friend (Part 2)

For investors, inflation is the erosion of your money, a “cancer,” if you will. It is the slow, subtle decline in what your money buys or the purchasing power of your money. Last month we covered what inflation is, how it works, and where it may be heading in the future. If you’re unfamiliar with inflation, I’d encourage you to refer to my column published on Jan. 17.

People invest in income, either for today or tomorrow. Protecting the purchasing power of that income is critical. But investors want to have their cake and eat it too. To grow investments and income at a rate that outpaces inflation, one must be willing to endure the “wiggles” that come with stock investing. Investors may seek protection from volatility through bonds or fixed-income investments that don’t fluctuate like owning businesses (stocks), but this strategy is shortsighted.

Inflation punishes bond investors. In today’s financial market environment, you lose the purchasing power of your money in “low-risk” investments like bonds. The Fed has lowered interest rates to nearly zero, so you get paid less than inflation on a current return basis. More importantly, inflation over time compounds against the value of your bond investment. At a 3% inflation rate, a bond’s purchasing power value declines by 50% in just 24 years. Imagine a 60-year-old who may want less fluctuation in their portfolio; any money allocated in bonds will lose half of its purchasing power by age 84. Investors might believe this to be a “safe” investment, but a better definition is “secure.” That investor will get the nominal money back in the future but will lose half of their purchasing power. “Safety” is found in growing purchasing power, not cash stuffed in the mattress.

That is why we believe in investing in businesses that grow their dividend income by innovating day-in and day-out, selling their goods and services to everybody, every day, everywhere. They are incentivized to constantly do better; they can adapt to changes that arise, and we all know changes happen. Bonds cannot adapt; they don’t change. You bargain for a rate and a date to get your principal back.

Dividends are simple to understand. They are a portion of company profits paid to shareholders as a reward or sort of “thank you” for investing or being an owner in the company. Typically, dividends are paid on a quarterly basis and are a predetermined dollar figure, which can be expressed as a percentage of the momentary price of the stock. Dividends are often symbolic of a companies’ underlying strength. If a company can continue to pay shareholders through thick and thin, it is believed to be a stronger company. Furthermore, if they can continue to grow those dividend payments over time, they are seen as being in an even better position. Companies that have a track record of consistent dividend payments and continue to increase those payments at a frequent interval are those we like.

There are has two primary benefits to this approach. First, it addresses our goal of growing your income to outpace inflation. Dividend payments are real cash deposits; no selling is required. There is no need to wait for a stock to go up or to worry about market movement. We remind investors: dividends are real. They are cold hard cash. Second, it grants us access to the best America has to offer, tapping into the innovation and growth of some of the best companies in the world. While price appreciation is secondary, in our view, it’s always a bonus when it happens.

Regardless, this approach is one in which we have great confidence. Over a long enough time horizon, the stock market has always gone up. Through wars, depressions, pandemics, and politics, the market has generated a return for those willing to participate. We have no reason to believe this will change any time soon. People severely underestimate the power of compound growth. This misunderstanding can cause significant errors over long horizons. Time and patience are enduring qualities. Sometimes the wisest thing to do is to stay invested and do nothing.

A great example is soup. In 2020, the price of a can of Campbell’s Tomato Soup increased by about 15% from 86 cents to 99 cents. For more than 100 years, the size hasn’t changed, but the price sure has. A little over 45 years ago, in 1974, the soup cost about 12 cents per can. That points to an average inflation rate of 4.7%. As we age, the price of the things we eat, buy, use, and consume will continue to get more expensive. Investors who increase their income at a rate greater than inflation will do well, both now and into the future. So, as the Federal Reserve embraces inflation, keep in mind what that does to your assets’ value and, most importantly, the value of the purchasing power of your money. At the end of the day, it is all about growing your income to protect the purchasing power of your money.

If and when inflation returns, it will be a rude awakening for investors. Interest rate increases will cause those “safe” bonds to decline in price. Inflation will cause the prices of the things we purchase every day to increase. Rising income during a multi-decade retirement timeframe is not a luxury; rather, it is mandatory. The question is, are you prepared and well-positioned if and when inflation returns?

Steve Booren is the founder of Prosperion Financial Advisors in Greenwood Village. He is the author of “Intelligent Investing: Your Guide to a Growing Retirement Income,” published in March 2019. This column is not intended to provide specific investment advice or recommendations.

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