November 22, 2011
At the outset, we agree that inflation does hurt your buying power. However, an investment in stocks doesn’t cure the inflation problem. When inflation exploded in the 1970s, stocks declined by about 50% in 1973 and 1974. One substantial cause of this decline was high interest rates that accompanied that inflationary era.
Our solution to the inflation problem is to put in place a bond ladde. Briefly, a bond ladder is a strategy to have one or more bonds come due in multiple years. For example, if you have $100,000 to invest, you might have a $10,000 bond come due in each of 10 different years beginning in 2012 and ending in 2021. If your bond ladder is in place and inflation breaks out and results in higher interest rates, you will be able to increase your cash flow by reinvesting your bond proceeds as they come due and your excess interest income in higher yielding bonds. For example, if you are getting a 4% return and interest rates go up over time to 6%, your cash flow will increase by 50%. Thus, if your bond ladder is in place, inflation resulting in higher interest rates is your upside case, and not a reason for concern.
Now let’s take a look at what the inflation rate as measured by the Consumer Price Index (CPI) really means. There really should be two CPIs, one for a middle-class family of four earning around $50,000 to $60,000 per year and another CPI for rich people. President Obama says you are rich if your family earns more than $250,000 per year. The CPI is heavily weighted to real estate, food, and oil products. If the CPI goes up, it really hurts the middle-class family. However, it doesn’t hurt the rich family because the percentage of their income that they spend on food and oil products is a very small percent of their income. As to real estate, they already own a home. So why should rich people worry about inflation? We think that the possibility of inflation should not stop them from investing in bonds, particularly if they have a bond ladder.
Cash flow in retirement
If you are spending some of the principal returned to you from maturing bonds, then you will be reducing your overall cash flow in the future. If you are retired, you may prefer to have greater cash flow currently even if the principal declines. However, it is important to realize that the consumption of principal results in the gradual diminution of the portfolio’s ability to generate cash flow.
Though you may think that planning on living on the interest payments from your bond portfolio may crimp your style, accepting what is – rather than what you hope might be – may encourage you to more realistically look at your options. You may have many sources of cash flow or few.
You may decide:
- Early retirement is not in the cards for now if interest rates are very low.
- Start a small business you can manage in semi-retirement.
- Invest longer-term despite market fluctuations in value to achieve a higher return.
- Consider living in a lower-cost community.
In summary, we believe that cash flow from bonds is the key to successful investment planning and retirement planning.
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