INVESTING LONG TERM? DON'T OVERLOOK THE INFLATION FACTOR!

A penny saved is a penny earned, right? Not necessarily.  Thanks to inflation, over time that penny could be worth less than when it was first dropped into the piggy bank. That's why if you're investing — especially for major goals years away, such as retirement — you can't afford to ignore the corrosive effect rising prices can have on the value of your assets.

Inflation Under the Microscope

Just what is inflation, this ravenous beast that eats away at the value of every dollar you earn? It is essentially the increase in the price of any good or service. The most commonly referenced measure of that increase is the Consumer Price Index (CPI), which is based on a monthly survey by the U.S. Bureau of Labor Statistics. The CPI compares current and past prices of a sample "market basket" of goods from a variety of categories including housing, food, transportation, and apparel. The CPI does have shortcomings, according to economists — it does not take taxes into account or consider that as the price of one product rises, consumers may react by purchasing a cheaper substitute (chicken instead of beef, for example). Nonetheless, it is widely considered a useful way to measure prices over time.

Inflation has been a very consistent fact of life in the U.S. economy. Dating back to 1945, the purchasing power of the dollar has declined in value every year but two — 1949 and 1950. Still, inflation rates were generally considered moderate until the 1970s. The average annual rate from 1900 to 1970 was approximately 2.5%. From 1970, however, the average rate spiked to around 6%, hitting a high of 13.3% in 1979.¹ Following the high inflation of the late 70s and early 80s, rates have been closer to the 2% to 3% range.

What it Means to Your Wallet

In today's economy, it's easy to overlook inflation when preparing for your financial future. An inflation rate of 4% might not seem to be worth a second thought — until you consider the impact it can have on the purchasing power of your money over the long term. For example, in just 20 years, 4% inflation annually would drive the value of a dollar down to $.44.

The Cost of the Future

Based on an average annual inflation rate of 4%.

Or look at it another way: If the price of a $.37 postage stamp rises by 4% over 20 years, it will more than double to nearly $.81. A larger-ticket item such as a $550 color television would cost almost $1,205, given the same inflation rate and time period. What about that $21,000 automobile you just took for a test drive? It would soar to more than $46,014 under the same conditions.

Inflation also works against your investments. When you calculate the return on an investment, you'll need to consider not just the interest rate you receive but also the real rate of return, which is determined by figuring in the effects of inflation. Your financial advisor can help you calculate your real rate of return.

Clearly, if you plan to achieve long-term financial goals, from college savings for your children to your own retirement, you'll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation.

Investing to Beat Inflation

Bulletproofing your portfolio against the threat of inflation might begin with a review of the investments most likely to provide returns that outpace inflation.

Over the long run — 10, 20, 30 years or more — stocks may provide the best potential for returns that exceed inflation. While past performance is no guarantee of future results, stocks have historically provided higher returns than other asset classes.

Consider these findings from a study of Standard & Poor's data: An analysis of 20-year holding periods between 1926 and December 31, 2003, found that the average annual return for a portfolio comprised exclusively of stocks in Standard & Poor's Composite Index of 500 Stocks was 11.36% — well above the average inflation rate of 3.92% for the same period.² The average annual return for long-term government bonds, on the other hand, was only 4.78%. In addition, the study found that the stock portfolio did not suffer a loss in 697 separate 20-year holding periods. In every period, the annual rate of return for the stock portfolio was greater than the inflation rate. The bond portfolio outpaced inflation in only 329 of the 697 20-year holding periods — by a much lower margin.

There are many ways to include stocks in your long-term plan in whatever proportion you decide is appropriate. You and your professional financial planner could create a diversified portfolio of shares from companies you select. Another option is a stock mutual fund, which offers the benefit of professional management. Stock mutual funds have demonstrated the same long-term growth potential as individual stocks. S&P Fund Services tracked domestic equity mutual funds from 1983 through 2003 and found an average annual return of 10.92%. (Does not reflect sales charges or other expenses associated with purchasing mutual fund shares. Past performance is no guarantee of future results.²)

You might also consider tax-deferred IRAs and variable annuities, which allow you to select from a variety of investment portfolios, including growth-oriented portfolios. As you approach retirement, you can also shift assets within a variable annuity to a more conservative portfolio if appropriate.

Total Annual Returns for Stocks, Bonds, and Inflation

This chart tracks inflation versus the S&P 500 and long-term government bonds.² Large-cap stocks are represented by the total annual returns of the S&P 500. Long-term government bonds are represented by the total annual returns of long-term Treasuries (10+ year maturities). Inflation is represented by the annual change in the Consumer Price Index.

A Balancing Act

Keep in mind that stocks do involve greater risk of short-term fluctuations than other asset classes. Unlike a bond, which guarantees a fixed return if you hold it until maturity, a stock can rise or fall in value based on daily events in the stock market, trends in the economy, or problems at the issuing company. But if you have a long investment time frame and are willing to hold your ground during short-term ups and downs, you may find that stocks offer the best chance to beat inflation.

The key is to consider your time frame, your anticipated income needs, and how much volatility you are willing to accept, and then construct a portfolio with the mix of stocks and other investments with which you are comfortable. For instance, if you have just embarked on your career and have 30 or 40 years until you plan to retire, a mix of 70% stocks and 30% bonds might be suitable.³ But even if you are approaching retirement, you may still need to maintain some growth-oriented investments as a hedge against inflation. After all, your retirement assets may need to last for 30 years or more, and inflation will continue to work against you throughout.

Take Steps to Tame Inflation

Whatever your investor profile — from first-time investor to experienced retiree — you need to keep inflation in your sights.  Stocks may be your best weapon, and there are many ways to include them. Consult your financial planner to discuss your specific needs and options.

Points to Remember

1. When investing for long-term goals, you need to consider the effects of inflation on your investment returns.
2. Inflation is the rising price of goods and services.
3. Diversifying your portfolio with stocks and stock mutual funds may offer the best chance of beating inflation over the long term.
4. Remember to consider your time frame and risk tolerance when considering investments for your portfolio.

This information is provided by Standard & Poor's. Accuracy and completeness of any of the information cannot be guaranteed by Wachovia and its affiliates. The material is for your information only and is not an invitation to buy or sell securities mentioned. The information is not intended to be the primary basis for any investment decisions and is not designed to meet the particular needs of any individual. Consult with your financial advisor regarding your particular financial situation. Specific issues may require consultation with your tax advisor or attorney.

Copyright © 2004, Standard & Poor's, a division of The McGraw-Hill Companies, Inc. All rights reserved.



Wachovia Securities is the trade name used by two separate, registered broker-dealers and non-bank affiliates of Wachovia Corporation providing certain retail securities brokerage services: Wachovia Securities, LLC, Member NYSE/SIPC, and Wachovia Securities Financial Network, LLC, Member FINRA /SIPC.

Wachovia Securities did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wachovia Securities or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

The S&P 500 (a registered trademark of McGraw-Hill Companies) is an unmanaged index of common stock. Unmanaged indices are for illustrative purposes only. An investor cannot invest directly in an index.