Investments and inflation
A few days ago I was exchanging messages with a potential investor. I am always happy when someone discusses a 20 to 30 year savings plan, having an idea of the type of risk they are willing to take, the financial assets they are considering using and with an idea of following yearly reinforcements.
The biggest question for the potential investor was whether they should start with several small investments or invest the savings they have all at once. With the recovery of the stock market, the doubt generally makes sense and there are numerous studies on this, whether by Vanguard (1) or bloggers (2).
However, I realized that something was missing. Such a long-term investment plan must include inflation in the calculations, something that was not being done. In such a long period of time inflation can be extremely relevant. We plan to retire millionaires, but then we realized that 30 years from now the purchasing power of a millionaire is just over half the purchasing power of a current millionaire, assuming inflation of 2% a year, the ECB's target.
I must remember that this 2% target by central banks is in turn something relatively recent, having only started to be adopted by several central banks in the early 1990s (3) (4) (5) and formally by the FED only in 2012 (6). No one tells us that central banks are not going to change these targets being 4% inflation (3) or other much-discussed forms of monetary policy (7) that could drive inflation above 2%.
A long-term investment [...] plan should include inflation in the calculations.
Increasing reinforcements in line with inflation is critical to achieving our long-term purchasing power targets. We can not only increase in line with inflation, but also with a potential increase in the income of human capital and an improvement in the professional situation.
I leave here a graph of the loss of purchasing power over 50 years to an inflation of 2%, which, as I said above, is not necessarily what will happen because we do not know if the current monetary policy of several central banks will be maintained at the level worldwide. Mainly in the case of the FED and the ECB, and in his most recent speech the FED Governor stated that they were willing to tolerate inflation above 2% if they thought that this would be good for the economy, namely in terms of employment (8).
- (1) Dollar-cost averaging just means taking risk later – Vanguard
- (2) Dollar Cost Averaging vs. Lump Sum: The Definitive Guide - Of Dollars and Data
- (3) Inflation and Central Banks - Federal Reserve Bank of St. Louis
- (4) Inflation Targeting and How It Works – The Balance
- (5) State of the art of inflation targeting – Bank of England
- (6) Federal Reserve issues FOMC statement - January 25, 2012 – FED
- (7) Rethinking the FED’s 2 percent inflation target – The Brookings Institution
- (8) New Economic Challenges and the Fed's Monetary Policy Review - Chair Jerome H. Powell
With a degree in economics (2006) and a postgraduate degree in Finance from Universidade Católica do Porto (2010), he later realized that he shared the same enthusiasm for programming.