Overstated: Inflation Risk

[Scanner]

I wish I had the book and author but I was thinking today as I posted on the other thread where I read a theory that all of your investmetns should only be in Treasury Bonds (written some 15 years ago).

His theory was there was no such thing as "inflation risk" and that Treasury yields anyway are partially based on inflation and meant to outpace it every so slightly anyway and why risk principal?

He then cited examples how food costs had dropped, utilities had dropped (this was written when oil was cheap) and that it doesn't cost that much to live (if you live frugally was also a point of the book).

Other than healthcare and college (which always outpace inflation), he did make a good case and even with healthcare, you have Medicare as a societal benefit when reaching retirement.

His theory (and I don't entirely subscribe to it) really made me think about matters nowadays as you basically see housing and even some consumables deflating.

If the COL is -2% and a Treasury is getting 1%. . .maybe that's not bad. (when the general consensus is that it sucks, LOL)

I'm always one for different theories, whether it's ultra-risky or uber-conservative.

There's another financial manager specific to my field who only advocates buying muni bonds and just having tax-free insured income to live off of. Investing for income seems to be a lost goal, something Grandpa seemed to do years ago with dividend stocks and gov't bonds.

[disneysteve]

There is certainly some validity to that theory. When thinking about inflation, people tend to focus on things that have gone UP in price, ignoring all of the things that have actually gone DOWN in price. Look at technology, for example. Right now, you can get a very powerful, full-function computer for under $300. By Christmas, they may well dip below the $200 mark. Not all that many years ago, a personal computer was a luxury purchase. Now, they are within reach of most all working folks. Lots of other things are cheaper, too, due to mass production, cheap imports, globalization, etc.

[Scanner]

Yes, that was the case he was making in his book.

Maybe for retirement. . .Treasuries but for college, maybe you have go slightly riskier to offset inflation. No, I guess that really won't work, LOL.

YOu have to remember too that the majority of his book was "Dave Ramseyish" with living a frugal lifestyle so it really depends on how you want to spend your retirement.

I think I have come to know you a little, DisneySteve and you want to go on a lot of cruises. Therefore (and this is where I don't know you), your current frugal lifestyle may be a means to an end - to enjoy a semi-lavish retirement.

FOr me, living frugal is a lifestyle that allows me security in pursueing my vocations - different business ventures (of which I would have some travel), lecturing. . .all that in retirement. It is the end. I only want to visit 3 places (Iceland, Scotland and Hawaii). . .after that, I"m done, I think. I'll probaly always drive an old car/truck, and always live modestly as I don't care for caring for a big place and everything.

So. . .I don't have the "inflation" risk or maybe more appropriately, lavish retirement risk.

[Broken Arrow]

I think it's pretty bold, perhaps even naive, to proclaim that there is no such thing as inflation risk. Inflation risk is very real. The best example is to simply look at Zimbabwe.

And in any case, inflation (or deflation for that matter) isn't the direct concern. The direct concern is the issue of purchasing power.

For example, controlled inflation in itself isn't necessarily a problem, and can even be considered beneficial. In fact, that's why Bernanke deliberately injected all the liquidity into the markets, as it was vital to halt the deflation in order to ease the recession we are in.

For that matter, deflation isn't a problem either, so long as our GDP can out-pace it. The real problem lies in run-away inflation or deflation, when our purchasing power can not keep up, and thus, causing a vicious downward spiral.

Also, I don't know why the author would think that Treasuries are inflation-adjusted either. The interest rate is subject to their own market forces (via consumer demand through bidding), including the inflation-protected ones such as TIPS. And at any rate, even if inflation protection is guaranteed, it still doesn't address the real issue of purchasing power.

In the end, the true advantage of Treasuries is capital preservation, but it does so at the price of growth. Now, an all-Treasury portfolio might not be a big deal if you're someone who is conservative, have an adequate nest egg, and is maybe in their 60s and older. But for the rest of us, limited growth also means limited compounding, thereby stunting one of the most important assets that we younger people have: Time

That being said, I DO applaud the out-of-the-box thinking. Even if I should end up disagreeing. And for that matter, I really feel bad that I seem to disagree with you at every turn, Scanner. The truth is, I actually like you. You seem like a fun guy on the forums, and you come up with ideas that really get the mental gears turning. Such behavior, I think, should always be applauded and encouraged.

The "problem" is that I admit I am more of a centrist thinker who does believe in conventions such as diversification, dollar-cost averaging, index funds, and so forth. So, perhaps it's inevitable that I would end up disagreeing, but I hope that is never misconstrued as a personal grudge or agenda or anything like that.

The irony is, once upon a time in the not-too-distant past, a lot of passive investment concepts that we take for granted today was once considered to be very radical as well. This is especially true when you consider an industry that still insists that we individual investors may not know what we're doing, and if we don't have at least one or more fund managers working for us, then we're doing something wrong.

[disneysteve]

I think I have come to know you a little, DisneySteve and you want to go on a lot of cruises. Therefore (and this is where I don't know you), your current frugal lifestyle may be a means to an end - to enjoy a semi-lavish retirement.

I think, as I've often said, that it is all about priorities. I am perfectly happy to have a smaller, older home that is simply decorated, drive an older car bought used, wear low-end clothing that isn't the latest fashion, etc. We're also happy to vacation frugally, and that gets even easier in retirement thanks to off-season travel and last-minute vacation deals that we can't take advantage of now. I've seen last minute cruises for $299 that would be 3 times that if booked in advance (like we do now). I don't think we'll need a lot more money in retirement to maintain and even improve upon our current lifestyle.

[Scanner]

Broken Arrow:

Don't worry - you don't have to be so overpolilte to me (but thanks anyway). I know I tend to humor "off the beaten path" theories more than the average guy.

We all know that success is getting any plan and just sticking with it, even if you just buy Treasuries and you don't outpace inflation. You could do a lot worse by fiddle-faddling with an inconsistent investment program (which I admit I ahve been guilty) but being properly diversfied, indexed, etc rather than being consistent (mainstream thinking).

I tend to be probably the forum "contrarian" on a lot of things mainly because I have ignored my own analyses and gone with the Pundits here, sometimes to my regret.

Back in 2006, I actually came to the forum with my Janus Overseas fund up about 60% in a year and I said, "Maybe I should take some of this off the table. . .I mean, how much more can I ride this wave?" The forum was adamant - "You can't time the market, Scanner" and convinced me to stay in and "buy and hold" (the mantra of the day).

Thanks a hell of lot, BA (LOL).

No, seriously, if the market comes raging back, then you would have proved yourself right actually.

I am full of other theories - here's another doosie - IMO, the stock market has been artificially propped up and the bond market will actually dominate in the next 20 years.

How's that for a doosie?

[Broken Arrow]

Ah, the Janus thing. Well, if memory serves, while it's true that I do believe the market can not be timed, at the time, I also thought that your exposure to that one fund was too much, and therefore, it was indeed a good idea to take some off the table. I don't know if it came out sounding that way, but I've always thought that 30% was about the upper limits of what anyone should have in internationals anyway, and ideally less than that because internationals are so much harder to valuate.... That and many domestic large caps also have an international presence, making your real exposure even higher than what is allocated.

However, I believe you wanted to keep the fund, and that is specifically why you opened your account with Schwab right? I mean, I don't remember too clearly. If it was my fault, then I do offer you my deepest apologies.

But yes, I maintain that the future market can not be timed. (However, I am still going to try my luck trading within present market conditions.... )

I am full of other theories - here's another doosie - IMO, the stock market has been artificially propped up and the bond market will actually dominate in the next 20 years.

How's that for a doosie?

That's a doosie! Expecting a "Second Dip"? I am at least preparing for one.

Short term, I do agree that the market is artificially propped up. For example, a lot of companies are beating quarterly estimates with "profit" through "inventory rebound". The short, short version is that companies are beating estimates because sales have finally exceeded existing inventory.

However, the deceptive thing about it is why. It isn't so much that sales have picked up again, but rather, that the over-supply of existing, pre-recession inventory has finally been used up, making a company look like the they have returned to profitability. Again, a decrease in supply is not the same thing as an increase in demand, hence the "inventory rebound" rather than a true rebound.

That said, I remain extremely confident of the long-term prospects of the US stock market. Honestly, there are too many good companies out there that are doing amazing things, and on an global scale, that nothing short of an all-out thermo-nuclear war would take them down.

Now, I know that past performance is no guarantee of future performance, but over the course of the long term, the inherent nature of stocks and bonds are such that I highly doubt bonds would ever out-pace stocks. Maybe not in the short-run, I don't know, but extremely unlikely in the long run.

[Scanner]

No, in all fairness. . .if I was to take it out of Janus when I did. . .I don't think I would have put it in cash. . .and let's face it - everything tanked except cash - REITs, bonds, etc. I had already had half of it in silver, which tanked too but then has since recovered.

My theory on the bond market is this - in the 20th century 1/3rd of the time bonds outperformed stocks on ayearly basis. It hasn't really happened that way the last 30 years. With this artificial tampering, there's bound to be a correction as to what they are really worth on a market basis.

Coupled with the fact that I think alternative lending will need to be a driver of our new economy (ala your Walmart bonds you love), that is, banks aren't just going to do the job anymore, I postulate bonds will become more of a serious investment tool and maybe even the "staple" of a portfolio (or an oughta be staple) vs. the ol' trusty "Vanguard stock mutual funds."

[disneysteve]

My theory on the bond market is this - in the 20th century 1/3rd of the time bonds outperformed stocks on a yearly basis. It hasn't really happened that way the last 30 years. With this artificial tampering, there's bound to be a correction as to what they are really worth on a market basis.

It is hard to use past performance as a guideline here because the playing field has changed. Thanks to 401k's, Roth's, discount online brokers and such, the percentage of Americans who invest in the stock market either directly or indirectly is far higher than it was 30 years ago. Stocks used to be the realm of the rich. Sure, grandmom might have had a stash of AT&T stock, but individual stock ownership wasn't nearly as common as it is now. I think that alters the game.

[Broken Arrow]

Artificial tampering? Without proof, I don't think I can go along with that.

However, I do agree that there are some interesting things going on in the bond market.

For example, this recession has scared a lot of people, forcing a "flight to safety" to Treasuries. Consequently, interest return for Treasuries are like at an all-time low right now. (And all the more reason why an all-Treasury portfolio doesn't make any sense right now.)

At the same time, people are also taking flight from corporate bonds, causing the interest returns on those to skyrocket. Some of these corporate bonds are literally paying more than some stock returns! It really is an extraordinary time that we live in....

Of course, some of those returns are justified, given the risks involved. Plenty of examples out there, anywhere from GM to AIG.

However, my thesis here is that I believe there are bonds that are risky for a good reason, but there are also bonds that are deemed risky by proxy. And yes, the best example I have is the Wal-mart store bonds.

Seriously, Wal-mart is no danger whatsoever. In fact, they MADE $$$ through this recession! And yet, they are paying premium bond interest just because they're a corporation? It's like shooting fish in a barrel with this one.

Of course, Wal-mart isn't the only example, but it's the one that I am seriously considering buying. I only need one good bond to put my money into.

[Scanner]

I don't mean artificial tampering as in a conspiracy theory way (although I wouldn't rule it out, lol). . .I mean kinda like what DisneySteve noted - I think money has been overdirected into the stock market based on some accepted notion of "Well, this is where we ought to be."

Remember. . .to review the fundamental - a stock is speculative instrument. . .you are owner in something - you may be paid out or you may not. A bond is money lent. It's a debt instrument. It's secured by collateral to a certain extent and you are paid first. Dividends are scraps.

I just ask questions that no one else asks sometimes (like how pharm. co.'s immediately came up with 80 billion out of nowhere during healthcare reform, lol).

Anyway, the question is - why direct people to ownership over lending?

My God. . .the Republicans even talked about SSI being "privatized" 5 years ago. Think about how insane that seems now that the market lost 50% within months.

YOu seem to be partially agreeing with me that corporations are needing raise cash and banks just don't have it or are lending it. This opens up hte bond market for years to come and crap. . .bondholders are paid before stockholders so. . .why go with a stock?

Maybe we should all be 80% bonds and 20% stocks in the next 20 years. And maybe investing for income vs. growth will make a comeback.

Like Grandpa, I'll get my monthly bond interest like he got dividends from stocks.

[kv968]

Back in 2006, I actually came to the forum with my Janus Overseas fund up about 60% in a year and I said, "Maybe I should take some of this off the table. . .I mean, how much more can I ride this wave?" The forum was adamant - "You can't time the market, Scanner" and convinced me to stay in and "buy and hold" (the mantra of the day).

Hold on, wait a second there Scanner. Although I think I've been lumped in with the "Pundits" in the past, I also think I was one of the people who told you to take a little off of the top of that fund at the time.

Granted, I was also probably one of the ones who said you can't "time the market" also

[PetMom]

I agree with the fact some things are cheaper but a lot of these things are things we did not need 15 years ago.

A computer was a novel item and you could still even get tv reception with some rabbit ears or a super cheap cable option.

Cell phones were not in use by everyone either, now everyone in the family has one and a landline.

And computers may be cheap but look at the expense to have them - the hook up, internet, all the anti virus software, the software you have to rebuy when you upgrade (eg photoshop that we lost when we went to Vista). Then we got to have our little laptops we carry with us and some kids in school are required to have these now.

How could something not be subject to inflation when we there was not even a use for it 15 years ago.

Broken Arrow: good point - diversification is a good investment philosophy, it acts a buffer against inflation where investing in only one investment vehicle does not.

[Scanner]

diversification is a good investment philosophy, it acts a buffer against inflation where investing in only one investment vehicle does not.

I disagree - diversification is a buffer against market losses and volatility, not a buffer against inflation.

KV,

Fair enough. . .I just hold you all 50% responsible.

Now cough up my losses. . .

[Broken Arrow]

I disagree - diversification is a buffer against market losses and volatility, not a buffer against inflation.

Yes.... Well, diversification is specifically a passive form of risk management in which the goal is to provide the desired growth while minimizing the associated risk. Because, it IS possible to end up with more risk than is necessary to pursue a desired level of growth.

And of course, the subsequent result of risk is loss, including market loss. But market loss isn't the only kind of loss. For example, we can also suffer loss from inflation as well if the growth is not adequate.

In other words, the goal isn't necessarily to buffer against volatility in general, but the basic idea is to be exposed to it only as much as is necessary, no more or less. In the process, we also want to make sure the associated risk is minimized as much as is possible. And all the while, it attempts to accomplish all this using simple rules and concepts that are easy to grasp and use for the average investors.

That's what proper diversification can do for us....

Now, for us more active people, diversification certainly isn't the only form of risk management out there. There is also active investing and market timing that, in theory, can also manage risk. Obviously, how effective these more active methods are subject to a lot of debates.

For myself, even though I am still investing and trading actively, I am regularly reminded of how I may not be able to out-pace passive strategies simply because I am often wrong about the state of the current market conditions.