Another instalment in a series of articles detailing how to design a secure, income-producing portfolio.
According to the Consumer Price Index (CPI), for the 12 months ended January 2022, inflation soared to 7.5%, the highest annualised chance since 1982. During that same 12 month period, the S&P 500 rose 20%. Inflation decreases buying power and therefore must be subtracted from investment returns, otherwise you might think you are growing richer while you are, in fact, growing poorer. While inflation turned higher last year, stocks did as well. This means, that the stock market went up 20% in a year, while buying power decreased 7.5%, so we’re essentially enjoying inflation-adjusted return of 12.5%, right?
Well, no. That would be correct if the CPI were a good measure of the inflation that we experience in our daily lives. But it isn’t. The CPI methodology treats different categories of consumer goods separately. For eample, we see that the things we NEED – such as medical care, housing and food – are growing more expensive at a rate far greater than the average. Meanwhile the things we WANT, such as televisions, computers, cars and virtually all electronics, show very little inflation because CPI adjusts these categories for ‘improvements’. So if the average new car or iPhone costs 3% more than last year, but includes more technology, the CPI for that category will be much lower or even negative. For most of us, this does not average out to an overall inflation rate on par with the official number put out by the CPI. To put it bluntly: no one experiences CPI-level inflation. Depending on which alternative measure you use, experienced household inflation is approximately 2-4x the long-term average CPI rate.
The upshot of this is that most investors have sold inflation short. Their portfolios are constructed in a manner to benefit when inflation falls or remains low. If you hold your wealth in liquid securities then you’re essentially making a bet that inflation will remain low, because inflation reduces the return on those assets. The CPI encourages us to make that bet by telling us that inflation is reliably low. If we confronted the fact that the inflation rate, we actually experience is several points higher, we might not be as bullish on stocks and bonds, which offer no built-in mechanism to protect us from inflation.
