This is a continuation of my previous entry on Social Security.
I have received some comments, via my blog, e-mail and also directly from those know me in real life, questioning whether the rationale expressed in my previous post holds even considering the massive 'baby boomer' retirement. Some wrote saying that the demographic tidal wave that contributed to the economic growth over the past few decades in the U.S. is now going to 'sink' into retirement, implying those who were propping up the U.S. economy over the past few decades will soon be in need of being propped up themselves.
This point appears powerful at first glance, yet it does not seem to hold up to a basic analysis of current data. The millions of baby boomers who are set to retire from this year on out till early 2020s, are not going to drop off the map. Let's examine this from investing and consumption perspectives separately. If one agrees that a retiring boomer needs at least 60% of his/her pre-retirement income, a basic analysis shows that this money is not going to come from Social Security or personal savings. Let's examine the savings scene first.
Based on Federal Reserve statistics on net worth (2004 data), the situation is grim (median and mean data):
Under 35 years old = $14,200 ($73,500)
35-44 years old = $69,400 ($299,200)
45-54 years old = $144,700 ($542,700)
55-64 years old = $248,700 ($843,800)
65-74 years old = $190,100 ($690,900)
Over 75 years old = $163,100 ($528,100)
In analyzing data like the above table for the entire U.S. population, the median values are far more meaningful than the mean values, which inevitably skew up due to the high wealth disparity among every age group in the country. After all, U.S. is the country with the world's largest number of millionaires and billionaires. It is known that the top 10% of the U.S. is estimated to hold over 70% of the country's wealth and even across the world, the richest 2% hold half of all global wealth. So, let's forget the mean and focus on the median values.
About 50% of the people at or nearing retirement have a net worth below the $150-250K median range for the age groups from 45 till over 75. For the sake of simplicity, let's take the midpoint of this range ($200K) and consider, based on recent data, about 46% of this median net worth is in home equity. Taking this portion away (as housing is required even during retirement), the median investable net worth for this group is about $108K. When I plug this figure into an annuity calculator assuming a 6% moderate growth rate for a 30-year payout period, I get a fixed annual payout of $7,400 (not adjusted for inflation). An inflation-adjusted annuity may only start at about $5,200 a year (I got this for a 65-year old male using Vanguard's annuity calculator while making a few other assumptions).
The average personal income (2006 data from Social Security Administration adjusted for inflation till 2008) is about $41,000. Even if an average retiree needs only 60% of this pre-retirement income, the income needs during retirement are $24,600 on a post-tax basis for the first year, which will rise with inflation in subsequent years. The average beneficiary (May 2008 data from Social Security Administration) receives about $990 in monthly benefits or $11,880 in the first year of retirement. So, SSA benefits and the annuity payout (inflation-adjusted) yield about $17,000 in annual income. This still leaves a 30% shortfall compared to the $24,600 expense requirement and likely a 35-40% short-fall when you consider Medicare premiums (which will be deducted from the SSA payment) and maybe a 45% shortfall if one considers taxes (modest but still has some impact) at these income levels. The shortfall grows further if more than 60% of the pre-retirement income is required during retirement. Remember that all of this applies to the median case, so 50% of U.S. residents will fare even worse than this scenario.
What's the implication of all this? Even for the "median" baby boomer case, staying employed during his/her 60s and possibly into 70s is going to be required to maintain a reasonable standard of living. Guess what happens when the boomers continue to work till say, 70, instead of withdrawing from Social Security at 62 when become eligible? Those 8 years of extra employment generates 6.2% of taxes paid into the SSA system (~$2,500 of SS taxes at 2008 median income levels). This is a double-benefit for SSA. Instead of paying out benefits for 8 or more years, the system is now taking in taxes to shore up its fund. Even if some of the boomers opt for Social Security benefits in their 60s, they will need to supplement it with earned income as the median case example shows. Under current rules, every $2 of earned income reduces SS benefits by $1. All this can only mean that the SSA will have more to payout for those in the queue later.
Staying employed into their 60s and possibly into early 70s is the only option I can see for the current generation of 45+ year-olds with the median net worth figures cited above. So, contrary to being a strain, I see this as a strengthening of the Social Security system. I suspect this may be one reason why the trustees keep extending the year when the trust fund is expected to be fully depleted. I remember the first projection as 2030 about a decade ago, then they adjusted it to 2035, then 2038 and now they project 2041. I believe this will continue to be extended as people are forced to extend their employment horizons and delay taking their social security benefits.
Jul 17, 2008
Jul 14, 2008
Investment Risk & Market Timing
“O Fortuna! Like the moon everchanging, rising first, then declining.”
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
Jul 2, 2008
When Money is Turning into Confetti
Reading about Zimbabwe’s 1,000,000% inflation in recent times inspired the title of this post. I saw a beautiful picture of a 50 billion dollar note printed by the Reserve Bank of Zimbabwe. I have never owned or even seen a currency note with so many zeros. It is currently worth a princely sum of four U.S. dollars. Even if we ignore this extreme case of a sub-Saharan African country, there are examples of larger, more influential countries where inflation has been 1,000%+. They include Russia, Argentina and Brazil. Yes, that Brazil – the ‘B’ of the darling BRIC countries - where the last 5 years of impressive growth and amazing reforms have made it the most stable of all emerging markets, even with the global credit crisis in full swing. A 1,000% inflation results in the infamous long lines for bread, where the price of bread paid by people towards the end of the line is considerably more than what the people at the front pay. In a 1,000% inflation economy, a worker’s salary must increase by a factor of 10 every year, just to keep his standard of living the same. Pretty soon, the central bank printing the nation’s currency and the school children learning their multiplication tables will grow weary with the number of zeros added every month!
When money turns into confetti, what can the residents of a country do? If most of their money is in cash, it is essentially becoming worthless, as even interest-bearing accounts will not be able to keep up with hyper-inflation. Even before the interest rate is revised, the inflation beats the bankers to it. Bonds become practically worthless as the nominal value of the principal is diluted by an order of magnitude in just one year if the inflation is 1,000%. Stocks may hold a little value because the companies that make the essentials that people want will increase prices with inflation while looking desperately for ways to manage the hyper-inflating cost structure. Still, they are not safe havens for the long term because the economic base (i.e. the people’s affordability) weakens so quickly in a hyper-inflationary situation that no company can count on making long term profits in such a country.
So, what can a small investor do to protect his wealth? He can have a sizeable portion of assets in relatively stable “hard” currencies such as USD, EUR, GBP etc. Ah, I can hear some of you complain, these are fiat currencies that are backed by no more than the “full faith and credit” of the issuing countries. Sure, but compared to the faithless currency of a hyper-inflating country with poor governance mechanisms, this is a vastly superior choice. Yet, this option is not always available due to foreign exchange restrictions placed on many residents, especially those living in developing countries that do not float their currencies freely in the global market. The next option is to own “hard” assets like Gold and Real Estate. Both react differently, in my view, during hyper inflation. Gold may preserve its value because it is a globally consistent and tradable asset with universal purity standards. Yet, owning gold physically carries risk and is expensive (due to transaction premiums and security charges) in many developing countries. Gold ETFs are not available in many developing countries but countries like India now offer gold ETFs for resident investors. Owning real estate on the other hand is easier but it is not liquid and it also has some risk, depending on the country’s property rights laws and enforcement infrastructure. Moreover, since all real estate is local, real estate may not offer a safe refuge in a hyper-inflating economy where the real affordability is declining and economic activity is shrinking. Whether real estate will hold its value in the long term in a country where affordability is declining is highly questionable. After all, the value of real estate is dependent on people’s ability to either pay rent or buy the property outright, both of which are dependent on economic prosperity.
Searching for an answer to this question led me to the Oracle of Omaha himself, who addressed this issue in a Q&A session. Warren Buffet said that the best thing an investor can do in a hyper-inflating economy is to invest in himself! This response deserves some careful thought. Regardless of what a currency’s worth is, a competent doctor or engineer or a hair stylist will earn his/her share of the economic output. Even within the same discipline, a highly skilled professional will earn more than his less skilled compatriot. In other words, skills useful to society never become worthless in any economy. In a country where financial investments are worthless, personal skill sets alone will ensure the long term living standards for individuals. This response is of course disappointing if you are, say, a septuagenarian investor, who no longer has the physical capacity for earning wages and so, depends only on income from investments. Well, old age sucks in any country, but it is brutal in a hyper-inflating country. This is why, owning hard currency-based assets becomes crucial for investors who have no other means of earned income.
Does the above apply even to ‘modestly high’ inflationary economies, say India and Southeast Asia, where inflation reached double digits recently? Staying employed is one of the best ways to deal with double digit inflation as incomes rise on par with inflation or better, at least for most skilled occupations. In addition, every year of staying employed is one less year to worry about income during retirement. On the other hand, facing a 15% annual inflation over a 30 year horizon can be brutal to an investor who is unable to earn income through employment. If you were hoping to retire on say, Rs. 50,000 a month ($1200 a month in today’s exchange rates), it is worth only about Rs. 12,000 a month in today’s value 10 years from now, barely Rs. 3,000 a month 20 years from now, and a piddly Rs. 750 a month at the end of your 30-year planning horizon. One way to protect the value of the initial Rs. 50,000 a month is to have it as a safe withdrawal from a well-diversified portfolio (that should have inflation-beating and likely volatile asset classes). This introduces asset price volatility (market risk) into the picture. So, depending on when your 30-year horizon begins, adverse market conditions may prevent you from withdrawing the same amount monthly (inflation-adjusted for future years) or you risk exhausting the portfolio before the 30-year horizon.
This is why I don’t always subscribe to the concept that all or even most of one’s assets must be in the country where the retiree lives. This advice, while sound for retirees in many “hard” currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one’s assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel “stupid” for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the “hard” + “soft” currency strategy of assets is that one’s returns would be lower because a sizable portion of the assets are in a ‘low yield’ country or a ‘high inflation’ country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.
And, in the remote possibility that you are reading this blog from Zimbabwe, I am told that the special paper and ink used to print currency notes has a decent heat index value, so you can save fuel costs while cooking your meals every day. You now have money to burn.
When money turns into confetti, what can the residents of a country do? If most of their money is in cash, it is essentially becoming worthless, as even interest-bearing accounts will not be able to keep up with hyper-inflation. Even before the interest rate is revised, the inflation beats the bankers to it. Bonds become practically worthless as the nominal value of the principal is diluted by an order of magnitude in just one year if the inflation is 1,000%. Stocks may hold a little value because the companies that make the essentials that people want will increase prices with inflation while looking desperately for ways to manage the hyper-inflating cost structure. Still, they are not safe havens for the long term because the economic base (i.e. the people’s affordability) weakens so quickly in a hyper-inflationary situation that no company can count on making long term profits in such a country.
So, what can a small investor do to protect his wealth? He can have a sizeable portion of assets in relatively stable “hard” currencies such as USD, EUR, GBP etc. Ah, I can hear some of you complain, these are fiat currencies that are backed by no more than the “full faith and credit” of the issuing countries. Sure, but compared to the faithless currency of a hyper-inflating country with poor governance mechanisms, this is a vastly superior choice. Yet, this option is not always available due to foreign exchange restrictions placed on many residents, especially those living in developing countries that do not float their currencies freely in the global market. The next option is to own “hard” assets like Gold and Real Estate. Both react differently, in my view, during hyper inflation. Gold may preserve its value because it is a globally consistent and tradable asset with universal purity standards. Yet, owning gold physically carries risk and is expensive (due to transaction premiums and security charges) in many developing countries. Gold ETFs are not available in many developing countries but countries like India now offer gold ETFs for resident investors. Owning real estate on the other hand is easier but it is not liquid and it also has some risk, depending on the country’s property rights laws and enforcement infrastructure. Moreover, since all real estate is local, real estate may not offer a safe refuge in a hyper-inflating economy where the real affordability is declining and economic activity is shrinking. Whether real estate will hold its value in the long term in a country where affordability is declining is highly questionable. After all, the value of real estate is dependent on people’s ability to either pay rent or buy the property outright, both of which are dependent on economic prosperity.
Searching for an answer to this question led me to the Oracle of Omaha himself, who addressed this issue in a Q&A session. Warren Buffet said that the best thing an investor can do in a hyper-inflating economy is to invest in himself! This response deserves some careful thought. Regardless of what a currency’s worth is, a competent doctor or engineer or a hair stylist will earn his/her share of the economic output. Even within the same discipline, a highly skilled professional will earn more than his less skilled compatriot. In other words, skills useful to society never become worthless in any economy. In a country where financial investments are worthless, personal skill sets alone will ensure the long term living standards for individuals. This response is of course disappointing if you are, say, a septuagenarian investor, who no longer has the physical capacity for earning wages and so, depends only on income from investments. Well, old age sucks in any country, but it is brutal in a hyper-inflating country. This is why, owning hard currency-based assets becomes crucial for investors who have no other means of earned income.
Does the above apply even to ‘modestly high’ inflationary economies, say India and Southeast Asia, where inflation reached double digits recently? Staying employed is one of the best ways to deal with double digit inflation as incomes rise on par with inflation or better, at least for most skilled occupations. In addition, every year of staying employed is one less year to worry about income during retirement. On the other hand, facing a 15% annual inflation over a 30 year horizon can be brutal to an investor who is unable to earn income through employment. If you were hoping to retire on say, Rs. 50,000 a month ($1200 a month in today’s exchange rates), it is worth only about Rs. 12,000 a month in today’s value 10 years from now, barely Rs. 3,000 a month 20 years from now, and a piddly Rs. 750 a month at the end of your 30-year planning horizon. One way to protect the value of the initial Rs. 50,000 a month is to have it as a safe withdrawal from a well-diversified portfolio (that should have inflation-beating and likely volatile asset classes). This introduces asset price volatility (market risk) into the picture. So, depending on when your 30-year horizon begins, adverse market conditions may prevent you from withdrawing the same amount monthly (inflation-adjusted for future years) or you risk exhausting the portfolio before the 30-year horizon.
This is why I don’t always subscribe to the concept that all or even most of one’s assets must be in the country where the retiree lives. This advice, while sound for retirees in many “hard” currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one’s assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel “stupid” for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the “hard” + “soft” currency strategy of assets is that one’s returns would be lower because a sizable portion of the assets are in a ‘low yield’ country or a ‘high inflation’ country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.
And, in the remote possibility that you are reading this blog from Zimbabwe, I am told that the special paper and ink used to print currency notes has a decent heat index value, so you can save fuel costs while cooking your meals every day. You now have money to burn.
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