Inflation is defined as the general rate of increase in the cost of goods and services and is the hidden tax that evaporates our purchasing power over time. Inflation is the result of more dollars chasing after fewer goods. Inflationary risk is one of the many risks that investors must cope with in the grand picture of retirement planning. While investing aggressively may create principal risk, being overly conservative may create inflationary risk.
According to the Bureau of Labor and Statistics (BLS), the cost of the average item purchased in 1984 for $1.00, would cost $2.28 in 2014. The BLS keeps multiple measurements of inflation using what is known as the Consumer Price Index (CPI). One of the versions of measurement, the CPI-U is used to determine the annual increase in benefits paid on national entitlement programs such as Social Security benefits. As the increase over a 30-year period clearly demonstrates, the cost of not investing with an adequate risk level can severely handicap one’s ability to maintain their lifestyle in retirement.
How accurate is the data the BLS has on inflation? Some of the evidence may suggest that the BLS CPI data may be underestimating the true cost of inflation in relation to the average American’s real world experiences. Over the decades the BLS has substantially modified the methods of how the official CPI data is acquired. At one time, prior to 1945 the CPI was known as the Cost of Living Index. It was determined by examining the cost of a fixed basket of goods with a constant weighting in order to maintain a “constant standard of living” for the average citizen.
Since 1945 many academic theories have evolved and developed around the topic of inflation and progressively moved away from the premise of measuring a constant standard of living. Many changes were made in the early 1980s and in the mid-1990s that evolved into the use of geometric weightings that altered the method of inflation based on consumer choices. As an example, if an individual could no longer afford to purchase filet mignon and instead began to buy less expensive pasta…the more expensive filet mignon would be reduced in weighting, while the less expensive pasta would be increased in its weighting on the CPI. While this may be a very fair representation of the actual behavior and activity taking place among consumers, to some, this is not a fair representation of the true cost of maintaining one’s lifestyle. Because eating pasta is not the same as eating a filet mignon.
Additionally, a number of hedonic adjustments were made to the CPI data as well. Hedonic adjustments are price adjustments to goods and services which are quantified based on quality changes. These adjustments are made via computer models using methods that are often viewed as somewhat cloudy and uncorrelated to real world experiences. As economist John Williams has pointed out, one such early example of a hedonic adjustment was the government regulations requiring the use of new gasoline formulas to decrease auto emissions. This initially had the impact of adding several cents a gallon, but the CPI excluded this increase as a quality adjustment, even though the consumer did actually pay the additional cost every time they visited the gas pump.
More recent examples are improvements in technology, which are used to artificially reduce the CPI. If a consumer purchases a new computer for the same price or more than the last computer they owned, the newer model may come with a number of new features which may be of no use to the consumer. These options may have been built into the computer. In the quality adjustments made by the BLS to the national CPI data, that more expensive model computer may have actually gone down in price even though the consumer may have actually paid more out of pocket. Yet, rarely are such quality price adjustments made in reverse. If an individual had to stand in line for an extra two hours to board a plane due to increased security checks, the BLS does not make adjustments to the cost of the ticket to reflect an increase in the price resulting from the decreased quality of service. Another example would be that the CPI data does not make adequate adjustments for the roll of paper towels that may cost the same, but has fewer sheets per roll than in years past.
The American Institute for Economic Research has compiled annual inflation data which is more directly linked to the cost of every day consumer purchases known as the Every Day Price Index (EPI). They have found at times a significantly higher inflation rate when compared to the geometric weightings used by the BLS, however, in some years their data was consistent with that of the BLS
A more thorough understanding of the BLS methods in determining the calculations in the rate of inflation is useful in forming an opinion on the accuracy of the data. It is quite possible that the BLS data is underestimating the true nature of the loss of purchasing power. If this is the case, the rationale for maintaining a longer term investment philosophy targeted with keeping up with and/or outpacing inflation is that much more paramount. While the current CPI methods suggest that broad based inflation is below 2%, many financial planners commonly model closer to a 4% baseline rate when projecting current trends. As a method to err on the side of caution, this allows a financial planner to place greater financial stress on the income projections of a retiree in order to more safely chart a successful course and prepare for the worst.
So when considering the impact of inflation on retirement plans, it may be wise to consider the difference between broad based CPI data versus the cost of more everyday items. Inflation is a serious risk to an individual’s retirement projections. Many of the economic theories used in calculating inflation may be quite useful in regard to political policy making and very long term forecasts. However, as an individual investor who is retired or preparing for retirement in the intermediate term, it may be important to look at the Cost of Living changes with a closer eye and emphasis on more everyday routine consumer purchases.
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One of the oldest debates within the investment community is between the benefits of value investing versus growth investing. Numerous arguments have been made in favor of both approaches at different times. A basic understanding of the two approaches must first be gained to evaluate a point of view.
Value Investing is based on the evaluation of securities which are trading at relatively low prices in relation to their earnings as well as other fundamental analysis. Value stocks produce returns that are most often comprised of both capital appreciation as well as dividends. These tend to be more established entities in comparison to their growth based counterparts.
Growth Investing targets securities which are expected to have faster rates of growth in the future when compared to the broad market indices. Growth stocks produce returns that are more often comprised of primarily capital appreciation and little to no dividend income. They are often more speculative in nature than their value oriented counterparts.
Value oriented securities are often viewed as more dependable because of the more consistent cash flow from dividends. However, in certain market environments they can be more volatile. As one such example, much of the large cap value sector is heavily weighted towards financials which can be a detractor in certain market environments. The S&P 500 value index is currently made up of a 25% exposure to the financial sector. In contrast the S&P 500 growth index is comprised of less than 10% financial sector exposure. During environments which may produce greater stress on financials, large cap value investing may be a more challenging task.
Historically, there have been various periods which have favored both value and growth investing over the short term business cycle. However, the timing of short term market movements has been an exercise in futility for the average investor and very often for investment professionals. The real question then becomes whether or not there is a clear winner over the long term performance trend.
The last decade has shown little evidence that either value or growth has been the dominant performer. The recent 10-year performance of Large Cap equities has given a slight edge to growth over value, with each having their years of outperformance. During the 10-year period ending September 2014, the S&P 500 Value Index had returns of 7.25%, while the S&P 500 Growth Index had returns of 8.90%. A similar result is seen when looking at the S&P 400 Mid Cap Value Index which had a return of 9.87% versus the S&P 400 Mid Cap Growth Index which returned 10.66%. The story is similar when looking at small cap equities; the S&P Small Cap Value 600 Index posted an 8.72% return, whereas, the S&P Small Cap Growth 600 Index had a 10-year return of 9.94%.
Taking a long term look over multiple decades has shown results that differ from the recent trend favoring value oriented securities. The academic work of recent Nobel Laureates, Eugene Fama and Kenneth French, in their Fama/French Three Factor Model has shown that value securities clearly outperform growth securities when given enough time. However, there are extended periods of time in which this trend can and has been reversed…an attempt to isolate a portfolio towards value or growth oriented securities can produce lower portfolio returns. Furthermore, this is in itself an attempt at timing market cycles, which has been historically difficult…if not impossible.
When looking at portfolio construction for the average investor, any bias in either direction should remain nominally tilted towards an increased weighting in one direction or the other. Often times the quest for cash flow resulting from dividends may drive an investor to heavily favor value over growth. As the last decade has demonstrated, this would have produced a lower cumulative return across US equities.
Investors focused on cash flow for the purpose of providing for and/or supplementing their lifestyle should be first concerned with aggregate returns. This is done by drawing cash flow proportionately from an overall strategic asset allocation that encompasses all asset classes and not simply on dividend income.
Dividends and value oriented securities are a fundamental part of proper portfolio construction. However, purchasing a security solely based on its dividend income is not a wise strategy. It is crucial to remember that dividends are not always a proper representation of the cash flow or the fiscal condition of an organization. Dividends distributions change, as do the economic cycles we must endure as investors. It is inevitable that we’ll face periods such as the recent decade in which less income oriented growth securities will outperform their value counterparts. Staying properly invested in a diversified allocation provides an investor the best risk adjusted probability of keeping pace with the markets and achieving their investment objectives.
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The real estate market can be a great investment opportunity for the average investor, if the timing is right. Real estate, like any asset class, is cyclical in its behavior. This can present short-term as well as long-term opportunities. Many investors have opted to buy individual properties as their primary residences as well as for vacation homes. These investors may purchase with the intent of renting one or both of these properties in order to generate cash flow.
Whether the discussion is regarding a residential or vacation property, becoming a landlord can be accompanied by a number of headaches. Not all property owners are interested in getting a call that there is a plumbing problem which will require the immediate presence of a professional. In regard to vacation homes, few investors will be able to fix it themselves, due to proximity as well as experience and ability. This type of overhead can create expenses both in terms of capital as well as time, and should be considered when looking at any investment. Additionally, due to the higher overall initial minimum investment and the difficulty in obtaining financing…many potential investors are priced out of the market.
There may be an easier way. Real Estate Investment Trusts (REITs) present the opportunity for individual investors to add real estate exposure to their investment portfolio. This is possible without the time and commitment required in making a direct purchase of an individual property. REITs are securities that typically trade like a stock on an exchange that individual investors can purchase into at any time. REITs are organized in the form of a Unit Investment Trust and can be broken down into two core categories:
An equity REIT will purchase and own individual properties which will generate cash flow via rentals which eventually pass thru to the shareholders in the form of a dividend. Additionally, the ownership of an equity REIT provides the shareholder the opportunity for capital appreciation in the value of the underlying real estate which may eventually be sold for a profit. Some equity REITs may have a specific concentration in certain areas of the market such as hospitality properties or shopping malls, while others can be extremely diverse in their underlying property holdings.
A mortgage REIT is an investment which owns the underlying mortgages of the real estate owners. Rather than owning equity in a property, the mortgage REIT shareholder is a creditor of the property owner. The REIT effectively holds the note on the property the same way a bank would hold the mortgage note on a home. Because the mortgage REIT market is more of a fixed income investment, it will typically be accompanied by higher dividend payments and less opportunity for capital appreciation.
Special Tax Treatment
The dividend income received by a REIT is typically taxed as ordinary income and will be taxed at the shareholders top marginal tax rate. The advantage is that unlike the stock of an individual company which must pay tax first at the corporate level and then again at the individual level, REIT investors will only pay the tax at the individual level. The reduced layer of taxation often means a higher return to the shareholder. Additionally, a portion of the dividend payment received by the shareholder can be deemed a Return of Capital to the shareholder. This means that this portion of the payment is treated as tax-free while deferring the capital gain on the underlying assets further into the future.
While a REIT will typically hold multiple properties in the trust, some investors may seek greater diversity. As a result, a group of REITs may be purchased as mutual funds, or exchange traded funds (ETFs) for a lower cost passive approach to investing.
What’s most important to note, is that real estate is just one of many asset classes that make up a more complete portfolio for a longer term investment strategy. However, regardless of an individual’s personal views on short term investment opportunities currently available in the real estate market, the REIT marketplace can fill the void for the average investor as a simplified solution with added tax benefits that will allow for diversified participation.
Additionally, REITs have shown an overall lower correlation to traditional equity benchmarks like the S&P 500. Today, as opposed to past decades, REITs exist in these traditional benchmarks. However, they only comprise about 2% of the S&P 500, the risk of redundancy is minimal and they can offer greater portfolio diversification.
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