If you had to define money, what would you say? For many, understanding purchasing power isn’t the first answer that comes to mind. It’s generally more common for people to think of money in terms of units of currency owned—here in America, for example, we would be talking about dollars. When we think of money this way, it seems logical to say that if we started out with one million dollars 30 years ago, and today we still have that same one million dollars, we succeeded in perfectly protecting our principal.
And we did! But what we haven’t necessarily protected is our purchasing power.
The difference between units of currency and purchasing power
The first thing to understand is that units of currency, like dollars, don’t always maintain the same level of purchasing power. Why not? Let’s have some fun with this. If we take our million dollars in 1989 (30 years ago) and decide to foolishly blow our money and buy as many Camaros as possible, we would be able to land 87 of those beauties, whose MSRP at the time was $11,5001.
But what if instead we decided to stuff our $1 million in our mattress and postpone our ridiculous hypothetical acquisition of Camaros for thirty years? With an MSRP of $26,0002 for the 2019 model, we would only be able to purchase 36 units of the sports car!
If we measured money in dollars, we can accurately say we safeguarded our $1 million nest egg. But considering the fact that we were only able to buy less than half of the same products, how well did we really protect our principal?
It’s plain to see that the modest inflation of less than 3% per year (the price increase the Camaro experienced) robbed us of more than half of our purchasing power.
How time impacts purchasing power
As time goes on, what we are able to purchase with the same units of currency decreases in proportion to the rate at which the price of services and products increases. Inflation, therefore, directly affects purchasing power, causing it to continually decline over time.
This brings us back to the question we started with: how do we define money? When we account for inflation, it doesn’t make sense to define money as currency, because what we can actually purchase with that currency is always dwindling. Instead of defining money as the dollars sitting in our bank account today, I would suggest focusing on the purchasing power it will provide over the coming years.
What does this mean for investors?
Because a fixed amount of currency will over time result in less and less buying power, I would argue that we should define investing success not as “protecting principal,” but rather as the pursuit of maintaining – and ideally increasing – our purchasing power.
While this concept is very basic, it is the cornerstone of setting the course of successful long-term investing.
Let’s look at a real-life example. Inflation over the past year has been 2.4%, while the yield on a 10-year U.S. Treasury note is 1.7%3. You would be hard pressed to find an investment with more “safety” than a U.S. Treasury note, but when you compare the rate of inflation to the note’s yield, it’s clear that the cost of safety is being locked into a continual erosion of purchasing power.
While it is our belief that bonds have a role to play in a diversified portfolio, inflation can render their perceived “safety” questionable.
Equities, on the other hand, have historically been more effective at maintaining purchasing power. However, the cost of owning equities is accepting the uncertainty of their short-term returns. There is no denying that equity values have experienced both sharp declines and advances on many occasions, and we fully expect them to do so again and again. But, leaning on the historical record, we can conclude that:
- The declines have been temporary.
- Any decline has been mitigated by a subsequent advance.
While our clients’ portfolios are tailored to their unique goals and objectives, our approach relies on the principles outlined above. If your investment plan is focused on protecting your principal instead of maintaining and increasing purchasing power, we invite you to connect with us to explore strategies aimed at preserving not just the dollars in your bank account, but your power to use them to make purchases over time.
- www.autotrader.com/chevrolet/camaro/1989 (Camaro 2 door Coupe RS)
- www.chevrolet.com/performance/camaro-sports-car/build-and-price/config (Camaro Coupe 1LT)
- J.P. Morgan 4Q 2019 Guide to the Markets, p. 30.