Guaranteed Loss

Sometimes when fear is at the extreme, investors can react emotionally and bail out when the pain is just too difficult to bear. I hear it all the time “I just can’t stand it—at least in my bank account or in a CD, I can’t lose money!” Au contraire…with inflation surging higher and interest rates at paltry levels, it may not occur to you that this simple rescue operation is actually the equivalent of a guaranteed loss.

Here is the simple math that is hard to see when you are confronted with a deluge of red arrows in your portfolio: by reallocating your portfolio away from the stock and bond markets and directing it into cash or CD’s earning about 2%, you are effectively locking in a loss of 2%. That’s because the rate of inflation is currently running at approximately 4%. And if you are unlucky enough to make this move in a taxable account, the news is worse because you have to pay taxes on what little interest you are earning.

But the alternative may not seem appealing. Perhaps you have heard that inflation is not too good for stocks or bonds either, which has historically been the case. It makes sense that inflation reduces the appeal of most financial assets, but only in extreme cases. According to Ibbotson Associates, in the 23 calendar years between 1926 and 2007 when inflation measured more than 4%, stocks returned 6.9% on average, versus 2.8% for long-term government bonds. The bad news is that when inflation goes well-beyond 4%, the numbers turn nasty. But very few analysts or economists think that is where we are heading, so perhaps we can put that particular worry to rest for now.

So what’s a freaked out investor to do when the markets are gyrating and the emotional surge of fear takes over? The first step is to revisit the game plan that you established before you started to invest. Even if you are a balanced investor, I am sorry to say that you signed up for some bad years—that’s the trade-off for the good years. Over time, things should even out and you will likely reach your goals.

If your emotions take over, then you may upend the whole plan. And remember, just because you don’t actually see the down arrows that inflation creates, does not mean that losses do not occur—they do! Over time, inflation will erode what little interest you earn and whether you see it or not, you will end up with less money—that’s a guarantee.