When You Reduce Your Risk, You Beat Inflation and Build Retirement Wealth
It seems so simple. To retire, most Americans just want to have enough money to sustain the lifestyle they have. Unfortunately, to plan for the retirement of your dreams, you have to take into account the risks that are seen and unforeseen, including inflation, healthcare costs, and the potential need for long-term care.
Inflation is the hour-hand of a clock. It’s hard to imagine the significant impact it can have on your retirement fund because of the slow and steady pace of price increases. Not planning for or even considering the cost of inflation could spell trouble for those preparing for retirement.
It’s an absolute given that, thanks to inflation, a dollar today will be worth less at retirement. Even a modest three-percent rise in prices means $100.00 worth of groceries today may cost $200.00 in 24 years. If you want your retirement fund to, at the very least, keep pace with inflation, you will need to broadly diversify your investments.
That doesn’t mean you need to throw caution to the wind and invest in more volatile stocks, thinking they will give you greater returns. Yes, you need to consider your investing risk level, but you also want to look at suitability, how far you are from retirement, and how long you want to be invested.
In spite of ongoing uncertainty and volatility, investors don’t need to take on higher-risk stocks to get higher returns. In fact, recent research shows that stocks with low volatility have provided investors with better returns than stocks that fluctuate more sharply.
One recent study tracked the returns of 1,000 stocks (with the largest market caps) using data from January 1968 to December 2008. Regardless of the risk factor, or whether they looked at all stocks or only large-caps, low-risk consistently outperformed high-risk stocks. (Source: Baker, Malcolm, Brendan Bradley, and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Financial Analysts Journal 2011; 67(1): 40–54.)
If you invested one dollar in the lowest-volatility portfolio in January 1968, by the end of 2008, your holding would have increased to $59.55. Over this same time period, unfortunately, inflation eroded the real value of your initial dollar to about $0.17; meaning the low-risk portfolio produced a gain of $10.12.
If, instead, you had plunked a dollar into the highest-volatility portfolio, it would be worth $0.58 at the end of December 2008. It gets worse: when you factor inflation into the mix, the real value of the high-volatility portfolio declined to less than $0.10. Investors who looked at volatility hoping it would generate the greatest returns would have realized almost a total loss in real terms.
Risk does not necessarily translate into higher expected returns. Investors hoping to pad their retirement fund with high-risk stocks may not want to shun low-risk stocks altogether.
One way to benefit is to consider companies that rise in step with, or outpace, inflation. The Procter & Gamble Company (NYSE/PG) is a company that will make more money when the products they sell cost more on the shelves. You could also look at companies that support Procter & Gamble with packaging and containers; including CCL Industries Inc. (TSX/CCL-B).
Oil companies will also grow in relation to inflation. Not just because Americans love to drive, but also because oil is used to heat homes and make asphalt. It is also used in plastics, tools, clothing, hand lotion, perfume, paint, glue, cosmetics, drugs, detergents, and pesticides.
You could also look for companies that people will turn to in order to ease the pain of inflation. While items will invariably cost more, there are less costly alternatives consumers will turn to. The ever-rising cost of health care and medication means that generic-drug manufacturers could experience significant growth in the coming years.
When you’re working, inflation may not feel like much of a burden. But, when you’re not working, inflation can significantly undermine the buying power of your retirement fund. Developing a realistic retirement plan doesn’t have to be overwhelming or risky.
Sometimes, slow and steady can be the quickest route to a rock solid retirement plan.