Wednesday, August 17, 2016

Why Low Inflation Is Better than Return (Just a Bit)

There are lots of complaints about the low return from stocks, bonds, and saving due to the intervention of central banks.  Central banks have driven interest rates down to negative levels in some areas, and this drives down the return on all other financial assets.

The return on a balanced portfolio of stocks and bonds is likely between 3 and 5%, which seems very low to most folks.

But inflation is also at low levels, 1-2% in the USA, and similar or lower rates elsewhere.

Should we care more about inflation or low rates?  At first glance, it should not matter.  If inflation is 3% and you are getting 6% return that should be the same as inflation at 1% and a 4% return.  Funnily enough, low inflation is slightly more beneficial than higher return by my calculations.

The formula for adjusting a return for inflation is:

Inflation-Adjusted Return

So let's look at some combinations of return and inflation:

inflationrate of returnDifference RoR & Iadjusted rate of return
3.00%4.00%1.00%0.97%
4.00%5.00%1.00%0.96%
2.00%4.00%2.00%1.96%
3.00%5.00%2.00%1.94%
4.00%6.00%2.00%1.92%
1.00%4.00%3.00%2.97%
2.00%5.00%3.00%2.94%
3.00%6.00%3.00%2.91%

For the same difference between return and inflation (third column), a lower inflation gives you slightly more return.  The combination of 4% and 1% (yellow) is slightly better than 6% and 3% (green).

This may be obvious to most people, but it was a bit of a revelation to me.  We should be a little thankful for low inflation in a time of low returns.

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