Inflation is one of those vagaries of economics that most people hear enough to have an idea of what it means, without being able to define it precisely. Why it's important to know exactly what it is - particularly for women.
I. What It Is
Inflation is simply the measurement of how much prices rise every year. The most dramatic example of inflation is the price of houses. When I was about six years old, my parents bought a house in a suburb north of Los Angeles for $35,000. Even with the dramatic downward adjustment of house prices in that area within the last few years, that house is worth over $750,000. Over that time, the price of that home has grown at an annual rate of over 6.25%.
The way an annual growth rate works is
Price multiplied by Growth Rate equals New Price.
For example, the first year would be $35,000 X 6.25% = $2,187.50. New Price is $35,000 + $2,187.50 = $37,187.50.
The second year would be $37,187.50 X 6.25 = $2,324.22. $37,187.50 + $2,324.22 = $39,411.72. As you can see, the amount of growth in the second year is higher, because the New Price in the second year is higher.
This additional growth happens every year, and is called the effect of compounding.
II. Inflation and Women
Women live longer than men. Consequently, their investments have to last longer than men's do, in order for women to last for their longer lifespan. When you add to our longevity the fact that we earn less than men (currently about $.80 to the dollar) and average eleven years outside the workforce as non-paid caregivers for family members, it's easy to see that we start with less money, and need to make our money do more, or risk facing poverty in our old age.
III. The Risk of No Risk
The recent correction has been a stark reminder that short term volatility is a fact of life in the stock market. Many have said, "I'm never putting money into the market again. I'm sticking with safe investments." While it is certainly an understandable reaction, it is one that could risk women's long-term financial well being. Here's why.
The common economic barometer for a "no risk" investment is the one year Treasury Bill. Safety is assured, as repayment by the United States Treasury is considered certain. As of October 16, the one year Treasury Bill is paying .36%.
You must pay Federal taxes on the interest earned on your Treasury Bill. Married people earning less than $137,050 have a marginal tax rate of 25%.
Inflation over the last year has run about .31%.
So, your actual return for this "safe" investment is
.36%, Interest Rate, minus
.09% Tax Rate (25% tax on .36%), minus
.31% Inflation (the rise in costs over one year), equals
After inflation and taxes (called "real return") you are behind where you started.
As a long term investment, this safe investment is a guaranteed loser.
IV. Some Other Types of Investments
We saw that the type of safety provided by Treasury Bills will actually lose ground over the long term. So, what's a girl to do?
Bonds are loans. Treasury Bills are loans to the US government.
You can also loan money to corporations, who will pay you back, with interest. Corporate bonds are rated as to the certainty of repayment. "Investment grade" bonds are considered safe, and "junk bonds" are just what they sound like. High interest and low probability of repayment.
An investment grade bond is currently paying 5.62% for eight years.
5.62% Interest Rate, minus
1.41% Tax Rate (25% of 5.62%), minus
0.31% Inflation equals
Your risk is that inflation will rise (as virtually every economist agrees it will) over the next eight years, and cut further into your return. But, at least you're staying ahead of inflation.
Owning stock is owning a piece of a company. Owning stock in just one company is very risky, because if that company has financial problems you can lose some, or in cases like Enron and WorldCom, even all of your money.
Most people diversify their investments by owning many companies. One way of doing that is to invest in an index, like the Dow Jones Industrial Average or the Standard and Poor's 500 Average. Since the Dow has 30 stocks and the Standard and Poor's Index has 500, the latter is a more diversified investment, and is the measurement against which most fund managers base their performance.
Over very long periods of time, the stock market's return is about 9.8%, about 3.5% of which is dividend payments.
9.80% Return, minus
0.85% Tax Rate (3.5% dividend payment times 25%), minus
0.31% Inflation, equals
There are a thousand provisos here. The growth in your investment (besides dividends) is taxable when you sell it. Current inflation rates are extraordinarily low, so your normalized return is more like 6.5% than 8.64%. But, in general, you get the point. Your money grows much faster in the market - EXCEPT there are predictable and certain big price fluctuations. You just saw one.
I've seen one in the 70's that took half the value of the market away in a long, grueling grind downward that lasted years. I saw one in 1987 that dropped far and fast. I saw one in the 90's. And there is this one.
So, short term money does not belong here. If you need it in five years, it doesn't belong here.
C. Real Estate
Real estate investments (not your home) have returns that are very similar to stocks. As you have seen, this too is a volatile enterprise. It's also highly specialized and takes a very large initial investment.
V. Risk and Return
If you know the risk, it is lessened. If you have a long term horizon, know that the stock market is VERY volatile and NEVER either sell in a panic - or invest money you need within five years - than you won't be spooked when the inevitable happens.
For those of us who are 50 and older, adding more bonds and lessening stock exposure is smart, as older women have less tolerance for price fluctuations than younger women. Some use the simple equation of subtracting their age from 100, and putting that amount in diversified stocks, and the rest in bonds.
VI. The Bottom Line
Let's say you're saving $7,500 a year for the next ten years for your retirement. Using the examples provided above:
In a Treasury Bill, you'll end up with $74,865 (less than your original investment).
With Corporate Bonds, you'll have $89,628
With Stocks, you'll have $112,008.
Yes, there will be volatility in the stock market. But, with your long term horizon, you'll know better than to panic and sell, and help yourself not be one of the 13% of women living in poverty at age 75.