You know the old story. Drop a frog in boiling water and it will immediately jump out. But put the frog in cool water and slowly heat the water to boiling and the frog just sits there and never moves. Whether the story is true or not doesn’t matter. It illustrates an issue of preparing for inflation. Inflation does not zoom from one percent to 20 percent in a month or a year.
Those of us old enough to remember living through the high inflation days of the 1970s remember it mostly as being launched by the OPEC created oil crisis. But it began a decade before. The consumer price index began the 1960s around one percent but had reach over 3% by 1967. It continued to climb and by 1970 had already touched 6% annualized. When the oil embargo hit inflation accelerated reaching double digits by 1974 and continuing at double digit rates until the early 1980s.
During that period of time the purchasing power of the dollar declined by 70%. . What that meant was, on the average what cost $1 to buy in 1960 cost $3 to buy in 1980.
It took over 30 years for the S&P 500 index to recover its purchasing power. In other words, the dollar amount of a $100,000 portfolio invested in the S&P 500 with dividends reinvested in 1960 would grow to $602,000 before it recovered its purchasing power.
Inflation generally takes years to develop. Inflation is either driven by supply or demand being out of balance. On the demand side it is too many dollars chasing too few goods or on the supply side it is rising wages and commodity prices. We have been seeing rising wages and in 2021 rising commodity prices.
This brings us back to the frog question. The numbers show inflation now is relatively tame but there are indications that it is slowly heating up, but there are a number of years before inflation boils. How can investors prepare?
There are lessons to be learned from the 1960-1980 period. Given the 70% decline in the purchasing power of the dollar, building a margin of safety would have meant having three times the purchasing power needed. In essence if a couple’s or individual’s living expenses were $51,916 (the 2019 US average income) they would need a nest egg big enough to sustain $156,000 of expenses to not change their quality of life. For a four percent withdrawal rate for $51,916 they would need a nest egg of $1,040,000 in addition to social security. To maintain quality of life should we experience inflation like the 1960-70s, they would need over $3 million. That difference is a “Margin of Safety”.
The bounce back of 2020 is the shortest on record. Most market recoveries take a lot longer. If counted in inflation adjusted terms, the drop that began in 1966 did not recover for 30 years. Stocks hits 1,000 on the DOW in 1966 and then bounced up and down for 16 years before going on to new highs. But inflation roared during that time and devalued the dollar by 70%. It took three times as many dollars on the average to buy the same goods in 1982 as it did in 1966. If the effect of inflation is included, the full recovery from the peak in 1966 until full recovery was 30 years.
The 2020 peak to full recovery was 140 days. Prior to that, the shortest period of recovery was 310 days. The average was 1,542 days (4 ¼ years). Not counting inflation, stocks took 30 years to recover from the beginning of the Great Depression of the 1930s.
Those are two periods of time when it took 30 years to recover.
The good news is there is still probably time to build that Margin of Safety. There is probably ten or more years to build, if in fact inflation does build. It means examining financial plans and adjusting to accommodate greater growth.
Most financial plans base the forward projections on historical data averages rather than those unexpected black swans like pandemics or black elephants like high inflation. The Monte Carlo simulation uses the bell shaped curves for calculating probabilities of having enough money. But the stock market is more of what I call a roller coaster curve. The stock market climbs more slowly than it plunges downward. The inaccuracies of the assumption of historical data and probabilities calculated on incorrect statistical assumptions may lead to investors feeling confident right until the moment they realize they do not have the margin of safety needed to survive that inflation mountain.
There is time to prepare. It means working backwards in a step process. The first step is to forecast what value of nest egg is needed ten years from now. The second step tripling that figure. Once that figure is tripled, the third step is to calculate what growth rate is needed to meet the higher estimate. The fourth step is to find the investments that over the next ten years will deliver the growth rate needed.
What happens if I am wrong about inflation and you have done the step by step process and find this ten years from now you have 3 times what you expected to need? You will have money to leave your heirs or community. Is that so bad?
No one ever told the frog in the cold water the heat was on and eventually the water was going to boil. Had the frog known, do you think the frog would have continued to sit in the water? No the frog would have realized the danger and left. Investors need to be like the forewarned frog and begin to prepare now.
Article Written by:
Mike Adams, President & Principal
Adams Financial Concepts LTD
206-903-1019
1001 Fourth Ave, Suite 4330, Seattle WA 98011
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