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Government-Reported Inflation

This article was written by in Economy. 8 comments.


Over the twelve months ending with March 2012, the increase in the consumer price index (CPI-U) as reported by the Bureau of Labor Statistics, often referred to as the inflation rate, is 2.7 percent (2.3 percent if you exclude food and energy). While these numbers are below the historically-cited norm for inflation, 3 percent, the numbers are still troubling for some people.

Government-reported increases in the consumer price index do not tie to any individual’s experienced increase in the cost of living. No person can assume that if wealth grows by the rate of inflation that life is just as affordable as it was a year ago. For example, if my income was $100,000 in 2011 and $102,700 in 2012, although my salary would be keeping pace with inflation, it’s likely that I still would find that this year’s income would not afford me as much as last year’s income was able to afford me.

Helium balloon inflationWith $100,000 in a high-yield savings account, the $750 I would have earned in before-tax interest not only loses to government-reported inflation, it would be pathetic compared to any rate of increase of expenses I experienced personally.

Part of the problem is that the CPI-U is calculated by measuring the change of price of a variety of consumer goods, but each type of good is weighted according to its importance. The level of importance is taken as an average importance across all citizens based in or near cities in the United States. Thus, the weighting may not be appropriate for any one individual. For example, as of the last CPI-U calculation, gasoline for vehicle fuel was weighted 5.7 percent. 5.7 percent of the year-over-year increase in consumer prices can be attributed to the increase in gas prices.

Any one family’s exposure to the cost of gasoline could easily be greater than 5.7 percent. A household with two incomes might involve a husband and wife who both commute an hour or more to, and an hour or more from, their places of work. For a family like this, the effect of an increase in gas prices could be much more devastating to their finances than the CPI-U would indicate. The increase in this category year-over-year is 9.0 percent. So if for any family, gasoline accounts for more than 5.7 percent of all expenses, the real cost of living would have increased more than the reported inflation rate.

We are often concerned with finding investments that provide a return higher than inflation. Financial planners consider inflation one of many benchmarks. If you want to maintain purchasing power with your funds, you’d look for a low-risk investment that meets or stays on par with the rate of inflation. The government even offers inflation-protected securities, whose yields are designed to artificially keep pace with the rate of inflation, thus providing investors a method of investing with a guarantee of not losing “purchasing power.”

The comparison between investment returns as experienced by one individual and a calculation of an average increase of prices is invalid. Financial experts continue to use the average inflation rate as a benchmark for individuals because it’s easy and can seem to apply to an entire population at once — even if it really applies to no one.

The criticism of the CPI-U as a personal rate of inflation doesn’t end with the idea that an average measurement doesn’t apply to any one individual. The method of calculating inflation has changed over time, and modern calculations are criticized for masking the truth. If the rate of inflation were to be calculated the same way it had been four decades ago, the rate would be significantly higher. The public is sensitive to bad economic news, and it’s safer for the government officials who are in power to continue to report subdued numbers. The Bureau of Labor Statistics should be free from political influence, but that’s an impossible ideal, especially over the course of a generation or two.

As a result of the realities behind criticism of the inflation rate, real inflation in the cost of living is destroying your net worth. Inflation keeps investors chasing returns that, while being better than earning nothing or losing money, are not high enough to continue a standard of living. Fifteen years ago, the most popular television sets might have cost an average of about $500. This was before LCD technology and high-definition became widespread. Today, the average cost of the most popular televisions might be $1,000. Today’s LED-backlit LCD HDTVs, while $1,000 today, would have cost more than $10,000 a few years ago when the technology was new. So in one sense, advancements in technology lower consumer costs, but offsetting that reduction is the consumer demand for better equipment, and that demand outpaces the decline in prices. Nobody’s buying the first generation iPad today.

Photo: Kai Hendry
Bureau of Labor Statistics

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How Do You Preserve Your Money?

This article was written by in Economy, Saving. 19 comments.

Preservation of capital is an important aspect of any financial plan, but in today’s economy, this is impossible without taking on some risk. At one time, you could confidently place any money you might need within one year in a high-yield savings account and be relatively confident that your money could buy at least as much a year in the future than it could buy the day you deposited your funds. Interest rates were relatively coordinated with the rate of inflation.

That’s not the case today. The Department of Labor released the latest inflation data. It should be no surprise to most consumers that the changes in the price of gas led to an increase in the energy index of 3.2 percent over the last twelve months (ending February). The inflation rate for all items is 2.9 percent. While the government-reported inflation rate doesn’t translate to the actual increase in expenses any one individual experiences year over year, it’s the best benchmark we currently have for a generalized view of the increase in prices.

And it’s the measure we use to determine how much purchasing power savers lose. If your savings account isn’t earning at least 2.9 percent after tax, you’re losing money in real terms by placing it in a bank. With banks offering less than 1 percent interest before taxes on their best high-yield savings accounts, purchasing power losses accelerate. Placing your cash under a mattress to earn zero interest is a worse idea, so are there any other options providing a safe way to maintain purchasing power?

Money BagsNot really. Using a savings account is great for funds you might need in an emergency, because you can access the money quickly without worrying about selling an asset. Savers have to understand that having an emergency fund is a compromise; in return for the safety of an FDIC-insured account, savers waive the right to preserve real value, at least in today’s economy.

Any other options for preserving capital introduce risk.

  • Investing in the stock market. Despite some recent frenzy about the stock market, with prices of the major indexes reaching near-term highs and day-over-day increases exceeding the best-performing day of the year thus far, there have also been daily price decreases reflecting the worst performance of the year. The stock market is incredibly volatile. For the long-term, it’s a good place to be, but there’s no guarantee that your capital will be preserved for when you need it.

  • Buying real estate. For years, families saw the house they live in as a way to store their wealth. The belief was unfortunately based on the myth that real estate values never decrease. Well, any asset can find itself in a bubble, whether they be tulips, stocks, or houses, and people who relied on real estate’s ever-increasing value to make a living have had a difficult time in recent years. It’s been terrible news for real estate flippers, but the effects hit single-house homeowners just as hard.

    Although timing the market is always dangerous, with low prices and low interest rates, if you can qualify and if the time is right for your family, now could be the right time to buy a house, particularly if you’re looking to live there for a long time.

  • Buying Treasury Inflation-Protected Securities (TIPS). You can buy this investment product directly from the U.S. Treasury. Twice a year, you receive interest as well as an adjustment to your principal balance based on the inflation rate. This is basically a bond that will only lose value in the event of deflation. If you must sell TIPS after the value has dipped below your initial investment, you will still receive your full initial investment back.

    There’s no risk in losing money, and this is the closest you might be able to get to true preservation of capital during inflation. Keep in mind, however, that the government’s reported inflation value doesn’t necessarily reflect any one household’s experienced rate of inflation. The government’s rate used for calculating TIPS adjustments, the CPI-U, uses the prices of a combination of goods that weights items in a way that might not be relevant to most consumers.

  • Buying gold. Investing in gold is traditionally a good way to hedge against inflation, but the price of gold fluctuates. Like all commodities, the value of gold at any particular time is subject to the whims of commodities traders. An investment in gold is not as stable as its reputation. The price fluctuation may be due to fluctuations in the value of the dollar or of any other fiat currency, but the cause is irrelevant because the U.S. dollar is the world’s standard for currency, and if that ever changes, it would be another currency or combination of currencies that becomes the standard, not a commodity like gold. The days of the gold standard are over.

    Furthermore, most people who invest in gold use ETFs or mutual funds due to convenience. It would be inefficient and expensive to store and secure a significant amount of physical gold bars. Once you are dealing with electronic trades rather than a physical manifestation of metal, you’re subjecting yourself even more to the whim of the financial industry.

With low interest rates and increasing inflation, this may be a good time, from a financial perspective, to borrow money. You can do more with someone else’s money, repaying the loan with money valued less in the future. Borrowing money is of course not a good idea for people who could find themselves in trouble with debt, as interest costs could spiral out of control, but if you look at the numbers, borrowers are getting a much better deal, relatively speaking, than savers.

In today’s economy, if you are preserving your money, how are you doing so?

Photo: Lord Jim

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Save Money at the Gas Pump

This article was written by in Consumer. 29 comments.

If you’ve stopped at a gas station lately, you might have been shocked to see the price on the big signs. Even if your gas station charges a different amount for credit card users than for cash customers, sometimes called a “cash discount” even though it’s the cash price that’s competitive with other stations, the lowest prices are higher than ever.

According to AAA, the average gas price across the country is now $3.76 per gallon. It’s not a record, but it’s getting close. Blame it on Obama, Bush, Iran, or Saudi Arabia; it doesn’t change the situation. The best we can do as consumers is to do our best to reduce our reliance on gasoline for transportation.

Gas Pump Fuel | crowt59Here are a few tips for saving money on gas.

  • Use technology to save money. Smartphone apps can tell you the locations of the gas stations with the best prices along your path. With this information, you don’t need to drive out of your way, wasting fuel, to get to those low-cost stations.
  • Use the best gas rewards credit cards. If your spending is in check, use credit cards that offer the best rewards for fueling your vehicles. If you can get 5% on your gas spending, you could have an advantage over people paying cash, but you’ll have to compare that option with the stations that offer a cash discount.
  • Maintain your car properly. Use a trusted mechanic, watch the performance of your tires, and keep your car clean and empty. Small changes in your tires and vehicle weight can affect your gas-mileage, so keep your car running efficiently.
  • Travel less. Work from home more often. If you’re shopping for a new job, consider mass transportation or car-pool options. In the last year, since working from home, I still drove 10,000 miles. That’s down from 14,000 miles over the prior year. The year before that, I drove 15,000 miles.
  • Consider a more efficient vehicle. While I generally don’t consider it a good idea to replace a perfectly functioning car just for efficiency, if you’re shopping for a new car, it may be worthwhile to buy something partially powered by electricity. This isn’t the best plan for all drivers, and the cost vs. benefit calculation often takes a while for the increased cost of these vehicles to break even through savings on gas.
  • Plan your trips efficiently. If you can combine your errands requiring transportation rather than venturing out several times each week, you can save gasoline and money. Plan your routes in a way that reduce the total number of miles driven rather than retracing your path.
  • Use an investing strategy to hedge against gasoline price increases. It may seem counter-intuitive when your plan is to reduce reliance on gasoline, but by investing in the oil industry, you benefit when companies profit from higher gas prices. If, however, companies don’t increase their profit with higher prices, then you’re stuck paying for higher gas without a strong investment to compensate.

About a year ago, I asked if Consumerism Commentary readers were ready for gas prices of $5.00. That level as an average is starting to look like a reality for the near future. While some commentators often remind Americans that people in other current countries often pay much more per gallon than those of us lucky to live in the United States, it’s not exactly a comfort to people who have built their lives around the ease of transportation.

What are your tips for saving money on gas?

Photo: crowt59

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Harry Browne’s Permanent Portfolio

This article was written by in Investing. 20 comments.

This is a guest article by Jacob, creator of the personal finance blog, My Personal Finance Journey. In the article, Jacob analyzes the Permanent Portfolio, a theory presented by Harry Browne, to determine whether investing along the theory’s guidelines can help investors beat the stock market.

Investors in general always seem to be on the lookout for a sure-fire strategy that they can use to outperform the market. Unfortunately, the reality is that these strategies are difficult-to-impossible to find. For this reason, I personally invest in a portfolio of passively managed low-cost index mutual funds from various asset classes and rebalance back to my asset allocation targets periodically.

Since my investing strategy does not take up too much time to maintain each month (in fact, individual stock investors might even call it “boring”), I am constantly interested in learning about new investing techniques and analyzing them to see if they have any merit.

One of these techniques/strategies I’ve learned about and analyzed over the past few months is The Permanent Portfolio created by Harry Browne in his book, Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.

What is the Permanent Portfolio?

The goal of The Permanent Portfolio is to provide safety and stability in any economic climate to the money you cannot afford to lose. This is accomplished by selecting various investment components in such a way that at least one asset class is favored in any economic climate. The Portfolio components are as follows, each carrying equal weight for as long as you hold the Portfolio, employing annual re-balancing:

  • 25% in stocks, which do well in times of prosperity.
  • 25% in gold, which does well in times of inflation.
  • 25% in bonds, which increase in price during times of deflation.
  • 25% in cash, which does well in times of tight money/recession.

Existing studies on the Permanent Portfolio

There have been many studies that have looked at this type of investing over the past 5 years. Overall, the conclusions and opinions from these existing studies are mixed. Craig from Crawling Road saw enough evidence from his study of the efficacy of The Permanent Portfolio, and he appears to have adopted it successfully to his investing strategy.

On the other hand, William Bernstein and Geoff Considine feel that while The Permanent Portfolio strategy itself has merit, individual investors who flock to this strategy are most likely “chasing returns” and probably lack the discipline to stick to the allocation dictated over the long-term, causing failure/loss of money to occur. This is due to the fact that the portfolio could be essentially flat-lined while the overall stock market is increasing 20%! An investor must have the discipline to stick to the strategy in these sorts of times.

I was not ready to automatically execute The Permanent Portfolio strategy for my own investing after reading the existing studies above for the following reasons:

  1. The use of raw index prices in existing studies is not ideal. I would want to still see good performance and risk trends when common investment vehicles (ETFs or index funds) are used exclusively to construct the portfolio.
  2. Use of physical gold metal holdings in existing studies is not ideal. Since the studies discussed above used gold market prices, I’d want to perform my own analysis using an index fund or ETF to see how performance held up without the use of physical metal.
  3. Permanent Portfolio performance comparison against a more aggressive stock asset allocation. In the existing studies, the most aggressive asset allocation that was compared against The Permanent Portfolio was a 60% equity, 40% bond asset mix. However, for a younger person such as me who can take on more risk, I would be curious to see how the performance compares to a more aggressive equity asset allocation, such as 75% equity, 25% fixed income.
  4. Use of yearly rebalancing in existing studies is not ideal. I currently employ monthly portfolio analysis (and rebalancing if needed), and as such, I’d be interested to find out how The Permanent Portfolio fairs using monthly rebalancing analysis.

Refined Permanent Portfolio performance analysis

In order to address the four considerations in the previous section, I set about defining the financial instruments that would construct The “Refined” Permanent Portfolio, a hypothetical portfolio consisting of a $10,000 starting value. The components I selected are shown below.

  • 25% in stocks – Vanguard S&P 500 Index Fund (ticker symbol: VFINX).
  • 25% in gold. Vanguard Precious Metals and Mining Fund (ticker symbol: VGPMX).
  • 25% in bonds. Vanguard Long-Term Treasury Fund (ticker symbol: VUSTX).
  • 25% in cash. Vanguard Short-Term Federal Fund (ticker symbol: VSGBX).

The table below summarizes the performance of the Refined Permanent Portfolio described above over the last 20 years (ending the beginning of October 2011) compared to a 100% stock and a 75% stock, 25% bond portfolio. The historical prices data source is Yahoo Finance. Monthly rebalancing is performed to maintain the appropriate asset allocation targets.

Permanent Portfolio Performance Table

Examining the table above, it can be seen that the Refined Permanent Portfolio does indeed outperform both the 100% stock and the stock/bond portfolios by a significant margin, as evidenced by nearly a 60% improvement in return on your original investment (20-year overall ROI), along with exhibiting 30-70% lower risk (lower standard deviation of annual returns).

Essentially, The Permanent Portfolio resulted in overall greater returns because it is insulated against the big decreases in price stemming from the often-volatile stock market. This phenomenon is best illustrated by the graph below, which shows the investment value growth of a $10,000 starting investment in the Refined Permanent Portfolio (blue plot) vs. a 100% stock portfolio (red plot).

The enhanced stability of the Permanent Portfolio was especially apparent in the 1997-2002 time frame (see black square in graph below), when the 100% stock portfolio first increased by more than 100%, only to then decrease nearly 50% in one to two years. The Permanent Portfolio was protected from this huge swing in prices, effectively preserving investor capital.

Permanent Portfolio Graph

Should investors incorporate the Permanent Portfolio?

Because of the consistency of the Permanent Portfolio over the past 50 years in either being competitive with or exceeding the long-term returns obtained using traditional stock/fixed income portfolios, I am convinced that The Permanent Portfolio will continue to perform well over the long-term.

However, I believe that investors should only adopt the strategy in full if the following conditions are true.

  • They will truly stick with it over the 20 years needed to obtain results competitive with or beating stocks, or
  • If they are merely looking for a conservative (not market-beating) strategy to preserve capital and stay ahead of inflation (which coincidentally, is the true goal for The Permanent Portfolio).

However, honestly, I feel that few investors (myself included) will have the resolve to stick with the strategy for the long-term, for the reasons mentioned below.

  • The majority of investors that are interested in The Permanent Portfolio at the current time are simply looking at it as a possible way to “beat the market,” and not as a method to preserve capital, as it is truly intended.
  • The Permanent Portfolio strategy’s returns have a low correlation with the returns of the stock market (a correlation coefficient of 0.58), meaning that if you employ this strategy, you’ll only enjoy any gains happening in the stock market about half the time. (Tthink about completely being excluded from the euphoria of the increase in the stock market in the late 1990′s. Would you be OK with that?) In my opinion, the low correlation of The Permanent Portfolio with the stock market makes it nearly impossible for investors looking to aggressively grow their money to stay with The Permanent Portfolio strategy.

Instead, most investors would be better served by sticking with an investing strategy using and a more “traditional” asset allocation that has a slightly higher correlation with the overall market.

Do you think that the Permanent Portfolio will continue to perform well in the next 20 years? Do you feel you’d have the discipline to stick with the strategy, even if it meant underperforming the rest of the market for long periods of time?

The complete set of calculations of the historical performance of the “Refined” Permanent Portfolio, correlation coefficients matrices, and price history of the proposed index mutual fund Permanent Portfolio is included in this Google Docs Spreadsheet.

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Good Debt and Bad Debt

by Flexo
See-saw

Misuse of credit can destroy a family’s financial life. A household can crumble under the weight of debt, whether it has increased from a poor house-purchasing decision, a drastic change in the real estate market, a shopping addiction, an unexpected medical bill, or the lack of preparedness for an emergency. It’s no surprise people consider ... Continue reading this article…

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How to Love Cooking

by Forest
Toast

This is a guest post by Forest from Frugal Zeitgeist. Forest writes about frugality, finance, minimalism and lifestyle. In this article, Forest shares his experiences in the kitchen. Cooking great meals is a great way to save money and stay healthy, but it’s a skill that I haven’t developed for myself. Passion can boost motivation, ... Continue reading this article…

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12 Alternative Financial Resolutions for 2012

by Flexo
New year hat

New Year’s resolutions have become so cliché that the process of making them has become a joke. People settle for mundane goals for the year like “losing weight,” “quitting smoking,” and “getting out of debt.” These are great goals, of course, but most who think about these only when the calendar changes soon forget their ... Continue reading this article…

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New Year’s Resolutions Help Even If You Don’t Keep Them

by Flexo

As the year draws to a close, I plan to take some time to evaluate the progression of my life, including my finances, against my goals and resolutions for 2011. I reached some goals while missing others. There are many reasons people don’t keep new year’s resolutions, and I’m not any different. In one recent ... Continue reading this article…

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