Inflation


W

Will Trice

Two things - as we've discussed here so many times before,
Buffet himself suggests massive diversification and indexing
for those who don't have the time or knowledge or skills to
manage active, more concentrated portfolios.
I don't know, I've heard (on CNBC) Buffett say to just go out and buy an
S&P 500 index fund. Is that what you meant by massive diversification?

-Will

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D

Don

I don't know what you've been reading, but I know that I've been
reading about inflation in financial planning for quite some time.
Perhaps Google this group, you'll see plenty of hits in that time
period.
I would bet that if you collected every book, newspaper article, and
newsgroup posting written about financial planning over the years,
counted the number of times the phrse "inflation protection" appeared
and plotted the results on a graph as a function of time-- and then
compared that to a graph of actual inflation statistics--there would be
a close relationship between the two, with possibly a slight time lag
from the former to the latter. I can't prove it, but I can speculate!

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I

Ignoramus29035

I have to ask, why do you think $1M@37 is "nothing special"? I'm
working on a project aimed at savers/investors your age and that
issue is coming up - highly inflated ideas about how much wealth is
out there. What makes you believe it's not a big deal/nothing
special? (I believe today that would be in 98th or higher percentile
for 37 year olds).
I just do not feel that it is a lot of money or that I could afford
something extravagant without negatively impacting other priorities.
Regarding inflation - your thesis is somewhat extreme, predicting
inflation rates much higher than those suggested by current market
indicators. I'm not going to try to talk you out of that, but would
challenge it: why 15-20%? You probably have some specific reasons
why you think inflation will be that high. And they could point at
methods of hedging that risk. For example if it's based on $200/bbl
oil then that could be your focus...seeking to profit from $200/bbl
oil while avoiding investments in the companies (including
oil-industry companies) that would be hurt by it.
I think that the current deficits (trade and budget) are very
substantial, the political process to rein them in does not work well,
the projected deficits are routinely underestimated, and also that the
current Fed policy of "stimulating" the economy is inflationary. The
wars that we are in, are not going away.

The projected inflation number, as always, is a matter of opinion, but
I think that inflation will be very noticeable.

5 years of 15% inflation roughly halves the value of the cash that one
would hold (and bank interest, after taxes does not fully
compensate). So the utility value of all those years of working more
than I needed, not spending money etc will be halved in value. Not a
very pleasant thought.

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K

kastnna

I just do not feel that it is a lot of money or that I could afford
something extravagant without negatively impacting other priorities.
I think the dissention lies in that *compared to your peers* you are
doing great. However, you are probably right that you could not retire
today and live the lifestyle you desire. Both statements are probably
correct. They do not contradict because they do not pertain to the
same argument.
I think that the current deficits (trade and budget) are very
substantial, the political process to rein them in does not work well,
the projected deficits are routinely underestimated, and also that the
current Fed policy of "stimulating" the economy is inflationary. The
wars that we are in, are not going away.
We are each entitled to our own opinions, that's for sure. As for
mine, I don't worry too much over trade deficits. Many economists
(including nobel prize winner Milton Friedman) actually consider a
trade deficit to be a GOOD thing.
----------
From a 1998 Senate Finance Commitee Hearing:
"Since 1980, the U.S economy has grown an average of 3.1 percent in
years in which the current account deficit has expanded from the
previous year, and an average of only 2.0 percent in years in which
the deficit has shrunk. If trade deficits are bad for growth, why does
the U.S. economy grow more than 50 percent faster when the trade
deficit expands?

Frankly, we would have more reason to worry if the U.S. were running a
trade surplus. In Mexico in 1995 and more recently in South Korea and
other East Asian countries, trade balances flipped overnight from
deficit to surplus because of plunging domestic demand and the flight
of foreign capital. In Japan today, a soaring trade surplus has been
accompanied by record high unemployment. It's no coincidence that
America's smallest trade deficit in recent years occurred in 1991--in
the trough of our last recession." (Testimony of Daniel T. Griswold,
Cato Institute)
-----------
As for our monetary policy, the last time we regularly saw inflation
on the scale you anticipate was in the late 70's to early 80's. At
that time we had a drastically different monetary policy that was, for
lack of a better term, the opposite of our current policy. Since
changing to our current policies, inflation has, historically, been
less volatile than ever before. What monetary policy do you suggest we
use (serious question)?

Furthermore, while you are correct that tinkering with the interest
rate *can* cause inflation, there's little evidence to suggest that
the Fed would allow that to happen. Quite the contrary, they have made
numerous statements that they intend to continously monitor inflation
and have even recently chosen NOT to alter interest rates just so that
they may contain inflation.
-----------

All in all, we may very well be "going to hell in a handbasket". It's
tough to say and I try not to form my opinion based on only a few
economic factors. Our macroeconomy depends on a multitude of things
and it is a full time job to fully understand and monitor them all. I
try my best to keep up, but I don't pretend to know everything.
Perhaps your predictions are correct, and perhaps not. Perhaps you are
even correct, but for the wrong reasons. Only time will tell.

For now, I remain optimistic. I do, however, get excited when I'm
against the general public sentiment. Turns out they're usually
wrong :)

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I

Ignoramus29035

Two cents: Unless one has deep expertise, I think holding
such a large proportion in a single company is unwise. I
suggest holding no more than 5% in any one company or even
sector. Yes to hedge inflation but also improve performance
while reducing risk.
Elle, the point that you are making is excellent and one that I think
a lot about.

So I will start going on a tangent, and hopefully will come back to
address your comment.

The question, is where is risk (of losing money) and how one can avoid
it. One can lose money due to investing in bad stocks/businesses,
stockmarket slumps, due to inflation, devaluation of currency, legal
problems, fraud etc.

Exotics aside, the risks in stock investing come from either paying
too much (buying a lot of stocks, but for too much money), or not
diversifying and being unlucky to make bad stock picks.

So, as far as stocks go, I have four choices:

1) do not invest in stocks at all
2) invest most stock money in Berkshire
3) Invest most stock money into an index
4) Make my own stock picks

My experience of a few years, convinced me that I am not a great stock
picker (no surprises here). I never lost all that much money, did not
lose anything around 2001, etc, and even made money, but I did not
achieve any spectacular returns on my "personal ideas". So 4) is out.

Warren Buffett's record, considering just the last few years, is much
better than mine, a little better than S&P (even though he pays taxes
and S&P does not), and he accomplishes that while carrying a
considerably lesser risk than than of an index fund.

I also like his thinking about risks, rewards etc, and the idea that
"to finish first, you must first finish". The main point of which is
that if there is a significant chance of a money manager losing
everything, then high average returns mean nothing, as in the end all
money will be lost one year.

So I think that having him maintain a diverse set of businesses and
stocks, is better than me trying to do same.

25% in the house, 30% in 401ks, the rest in some cash and Euro
denominated bank accounts. About 1 million net worth (which is not
a big deal any more). Nothing special.

My question is what sorts of investments, would, more or
less,
compensate the owner for inflation[?]
If inflation is fairly uniform across all products and
services, have you considered that company earnings will
also similarly inflate? Company earnings and inflation are
inextricably tied together, after all.
They are not, it is not that simple. Inflation is basically a tax on
cash, accounts receivable etc and rewards accounts payable. So some
companies will lose more than others, depending on their business
model, but on average they will lose money (real economic value) from
inflation, just as private people would.
Hence I think the most rational hedge against inflation is a diverse
portfolio of stocks. The one alternative to consider is as Dave
suggested: TIPS. Yale Academic Robert Shiller is a fan of these. You
might google and study what he has to say on this.
Yes, the TIPS idea is definitely one worth studying.

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I

Ignoramus29035

I would not say larger capitalization can justify a larger
allocation. Plenty of large cap companies have had disasters
visit them, driving their share prices down to half or less.
OTOH, if you are saying that BH has diversified so that it
owns many businesses, and so owning a share of BH is like
owning a share of a well-diversified mutual fund, I might
buy this, in part. In my view, BH still has a single board
of directors, and the directors can still make mistakes and
destroy the company.
I have Bs, but they are the same as A's, sans the multiplier.

The above is roughly correct, I have slightly more money in it, but
not by much.

i

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I

Ignoramus29035

I find it extremely interesting how inflation has become a much
discussed topic recently. Just a year or two ago, all sorts of ideas
about financial planning were being tossed around with hardly any
mention of inflation. It is almost as if people believed that it would
never again be a problem. In contrast, I can remember the days in the
early 80's when "inflation protection" was, if not the number 1
consideration, was at least #2 or #3 in any and all discussions of
planning for the future financially. So it seems like attention to this
topic parallels the existence or non-existence of inflation itself. The
phrase "closing the barn door after the horse is already out" comes to
mind.
Good point, but moderate inflation means gradual loss of money. So if
one notices it half a year late and takes measures, it is still
worthwhile to take them.

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I

Ignoramus29035

That might not be a bad idea. Not everything, but at least some of your
money in rental property could help. One thing I noticed a long time
ago is that rents keep going up over the years along with inflation,
but the mortgage payments always stay the same! And once the mortage is
paid off, the yield can be very attractive. My wife and I have done
well with rental property. People may tell you there is a lot of hassle
in owning rental property, but if you have a good rental agent and/or
property manager, there is not as much as you might think. We own
property over 3000 miles away from our primary residence and do not
much trouble at all.
How costly is it for a "little guy" to have a manager?

i

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E

Elle

Warren Buffett's record, considering just the last few
years, is much
better than mine, a little better than S&P (even though he
pays taxes
and S&P does not), and he accomplishes that while carrying
a
considerably lesser risk than than of an index fund.
That BH is less risky than the S&P 500 is not clear to me.
Maybe Will Trice or someone else can post some meaningful
numbers to compare the two. Either way, you heard out the
exchange on the subject here; you sound at least a little
grounded in the concept of diversification; you selected BH
partly because it is conglomerate-like; you say you have
another 30% or so in 401(k)s, which I imagine is in mutual
funds; and it sounds like you are happy with BH as opposed
to an index fund. I would not choose a 30% allocation to any
one stock (even BH), but others would be comfortable with it
and, like you, can justify the decision. BH may very well go
on beating the S&P 500 for the long run.
They are not, it is not that simple. Inflation is
basically a tax on
cash, accounts receivable etc and rewards accounts
payable. So some
companies will lose more than others, depending on their
business
model, but on average they will lose money (real economic
value) from
inflation, just as private people would.
We disagree, but no big deal.

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D

Douglas Johnson

Ignoramus29035 said:
I just do not feel that it is a lot of money or that I could afford
something extravagant without negatively impacting other priorities.
It is worth noting that, to retire on a middle-class income, say $40K a year,
you need a $1M in earning assets or the equivalent in annuities, such as
pensions or social security. This by our 4% withdrawal rule of thumb.

So $1M is not what it used to be. But it is way out front for a 37 y/o.

-- Doug

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D

Douglas Johnson

Ignoramus29035 said:
I think that the current deficits (trade and budget) are very
substantial, the political process to rein them in does not work well,
the projected deficits are routinely underestimated, and also that the
current Fed policy of "stimulating" the economy is inflationary. The
wars that we are in, are not going away.
Just to continue the discussion, none of those are inflationary except for the
Fed stimulus. Further, we are in a recession or close to it. That is a strong
deflationary force. -- Doug

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D

Don

How costly is it for a "little guy" to have a manager?

Anywhere from around 7% to 15% of the gross rents depending on the
location and type of property. I think it is worth the cost unless your
property is close to where you live and you have the time to handle it
yourself.

Whether you are a "little guy" or a big guy is not really an issue.
Having a manager is a good idea whether your rental property is a small
condo or a 30-unit apartment building. For a larger investment, the
manager costs more, but also there is more rental income to pay those
expenses.

Do the calculations and just make sure you will have enough rental
income to pay the mortgage, if any, and pay all the expenses. You need
to have enough cash in reserve to allow for vacancies of a month or two
if a tenant leaves, and to pay unexpected expenses like fixing a roof
or getting a new furnace. Good luck.

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B

BreadWithSpam

Yes, the TIPS idea is definitely one worth studying.
Perhaps as a small part of a portfolio, but note a few
things about them. (a) they are *highly* tax-inefficient -
do NOT hold them in a taxable account. And (b) the
"real" rate they are paying is very low. They may
beat inflation, but not by much, and if in a taxable
account, probably not at all.

They may be suitable for a part of the fixed income
portion of a more diversified portfolio. But TIPS alone
would make for a retirement which would be very difficult
to save for.

As the flight to quality proceeded recently and credit
spreads widened, yields on Treasuries went way down and
"real" yields on TIPS got to be tiny. When a recovery
takes place, that is likely to reverse somewhat (and
it already has - a little - yield on a 10yr TIPs in
March dipped below 1%. It's back to around 1.6 now and
got as high as 1.8 earlier this month. During most of
their history, these have yielded between 1.6 or so and
2.3 or so.). Point being that TIPs yields - and returns -
may protect somewhat against inflation, but not perfectly.
They still have term structure and interest rate risk,
and can get ahead of themselves in times of fear.
Vanguard's Inflation Protected Securities fund - which
is more than 90% TIPs - has had annual *nominal* returns
as high as 16% (ie. in times of fear - 2002) and as low
as 0.4% (in times of not so much fear - 2006).

Anyway, all I'm saying is that while TIPs may have a
place in a portfolio, they should only be a piece of
one, not the whole thing and one needs to be aware of
their problems.

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B

BreadWithSpam

Will Trice said:
I don't know, I've heard (on CNBC) Buffett say to just go out and buy
an S&P 500 index fund. Is that what you meant by massive
diversification?
Precisely. We've discussed it here before, but the basic
jist is that he acknowledges that the ability and expertise
to pick stocks is not very common, and that even those who
can do it spend a lot of time doing it. Folks who have
neither the expertise, ability or time for it should just
buy the whole market. No need to pick stocks.

He's even put his money where his mouth is - he recently
made a bet with some hedge fund managers that an index
fund will beat their fund of hedge funds over a ten year
period. See <http://www.longbets.org/> or any of the
articles easily found on Google such as
<http://money.cnn.com/2008/06/04/news/newsmakers/buffett_bet.fortune/index.htm>

Note that Buffett does not recommend index funds for
everyone. Just for many, perhaps most.

This is a good short article on Buffett's comments -
do look at the note attached at the bottom, though,
from Jeff Ptak at Morningstar:

<http://www.indexuniverse.com/blog/31/4081-buffett-just-buy-index-funds.html>

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M

Michael

It is worth noting that, to retire on a middle-class income, say $40K a year,
you need a $1M in earning assets or the equivalent in annuities, such as
pensions or social security. This by our 4% withdrawal rule of thumb.

I'm surprised by the stated 4% withdrawal rule of thumb. I thought 6%
was a conservative enough estimate to be realistic. Not so?
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B

BreadWithSpam

I'm surprised by the stated 4% withdrawal rule of thumb. I thought
6% was a conservative enough estimate to be realistic. Not so?
6% is pretty aggressive, and if it's 6% + inflation adjustments,
it's highly likely to fail (where "fail" means you run out of
money before you're ready to).

Note that a 100% equity portfolio over much of the last
century returned only about 7% after inflation. And that
was with a lot of volatility along the way. A balanced
portfolio, to temper the volatility, paid less. But such
a balanced portfolio may be steady enough to support those
payouts. Pulling a fixed (plus inflation) percentage out
each year can get you in a lot of trouble if you have
a few big down years early on. Timing matters a lot in
when there is volatility. Starting at 6% right when the
market takes off may look conservative. Starting at 6%, say,
in 1973 or in 2002, not so much. Since I don't know if we're
poised for another 2002 (well, we're on our way) or
if we're poised for another 1975/6, I'd weigh out
carefully what the consequences of being wrong are.

If you use a more flexible plan - pull out a fixed percentage
of your portfolio - and thereby pull out *less* in/after
down years - you might be able to sustain a slightly higher
extraction rate and still be reasonably certain that you
will be able to pull out enough on an ongoing basis to
sustain your cost of living.

Note that all such "rules" of how to do this need to
be able to be adjusted along the way, since they all
are based on projections and estimates into the future.


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W

Will Trice

Elle said:
That BH is less risky than the S&P 500 is not clear to me.
Maybe Will Trice or someone else can post some meaningful
numbers to compare the two.
I wouldn't dare try to come up with a number that would describe risk to
your satisfaction... :)

-Will

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D

Douglas Johnson

Michael said:
I'm surprised by the stated 4% withdrawal rule of thumb. I thought 6%
was a conservative enough estimate to be realistic. Not so?
Like a lot of things in retirement planning, it depends on how long you are
going to live. But 6% is definitely on the high side. Take a look at:
http://www.retireearlyhomepage.com/safewith.html for an overview and references
to more detailed studies. In particular, look at the Trinity Study.

-- Doug

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T

TB

Ignoramus29035 said:
I just do not feel that it is a lot of money or that I could afford
something extravagant without negatively impacting other priorities.
OK then how about a more global perspective? The 2007 Capgemini/Merrill
Lynch Worldwide Wealth Report estimates that there were only 9.5 million
millionaires on the entire planet in 2006. They define this as $1M
excluding principal residence so you're not quite there yet, but you're
well on your way given that you're only 37.

Or put another way, 99.99985% of the earth's population has less than
$1M and somehow they are able to scrape by. And if high inflation is
going to threaten your lifestyle, think of the effect it's going to have
on those with so much less.

In that context, the contention that one needs substantially more than
$1M in today's dollars to retire, or even lead an enjoyable lifestyle
during one's working life, is absurd. It means one has overly
pessimistic views of the long-term value of financial assets, or
extremely high expectations for consumption. Figuring out which one is
the issue might help point to a solution...but some appreciation for
one's financial status is a good start.

-Tad

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J

joetaxpayer

TB said:
OK then how about a more global perspective? The 2007 Capgemini/Merrill
Lynch Worldwide Wealth Report estimates that there were only 9.5 million
millionaires on the entire planet in 2006.
This may be going off topic, forgive me, but to this point, there is a
web site http://www.globalrichlist.com/ which tells you where you stand
on a worldwide scale. $48000 is median in the US, right? On a world
scale it's the top 1%. Half the world's population lives on less than
$850/yr. This may not be relevant to how we plan our finances here, but
it does offer one an interesting perspective.

Joe

--------------------------------------
Misc.invest.financial-plan is a moderated newsgroup where Moderators strive
to keep the conversations on-topic for financial planning. Other posting
guidelines include a request for brevity and another for trimming posts to
which we respond. For all of the other tips and suggestions, see "FROM THE
MODERATORS: Posting to misc.invest.financial-plan", a weekly post now on the
Newsgroup.
 

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