Jul 01 2022 / Round the Table Magazine
The 3-minute inflation explanation that clients will remember
By Richard Dobson Jr., CFP
Inflation has devastating effects on our clients’ savings and investment accounts, and advisors must help them understand why it is a major factor behind our advice to allocate a portion of their core assets to equities.
Inflation is defined as a general rise in the cost of goods and services and a decline in the purchasing power of money. The cost of living is likely to continue beguiling economies after the U.S. saw the consumer price index hit a 40-year high during the first quarter of 2022. The European Union saw prices rise faster than at any time since the euro currency was introduced in 1999. Record-high fuel prices sent consumer inflation in Australia soaring; rising food prices in Pakistan pushed inflation to double digits, and even in Japan, where prices have been depressed since the collapse of the real estate bubble during the 1980s; the central bank there raised its inflation forecast for the first time in eight years.
The inflation threat needs our top attention. According to a study of U.S. stock returns since 1802 by Jeremy Siegel, Ph.D., of The Wharton School of the University of Pennsylvania, securities returned an inflation-adjusted 6.6%, and that number has been above 11% since World War II. But even a low 2% inflation rate can erode 18% to 45% of value over a 10- to 30-year range.
So how can we best communicate the risk of inflation to our clients and prospects?
- Keep it simple.
- Make it memorable.
- Have fun with it.
Don’t use graphs and charts. They’re uninspiring, and your clients and prospects eyes will just glaze over. I have a graph that shows the loss of purchasing power over time, but it lacks any real-world application. Instead, I show clients a 50-year-old U.S. postage stamp. A first-class stamp cost 8 cents back in 1972. Today, that same stamp costs 58 cents, which is a 4.2% average annual increase, a bit higher than the average annual consumer inflation rate of 3.9% during the same period. Clients immediately embrace this example because it is a simple and memorable way to show how inflation impacts a purchase to which everyone can relate. Complete the thought by connecting Siegel’s findings where a portfolio invested in a large company returned 6.6% minus the 4.2% for stamp inflation, and we get an expected real return of 2.4% trying to compound toward our clients’ long-term goals. The question for clients is, how many stamps will 58 cents buy 50 years from now? It is likely that 58 cents will buy only a small fraction of a stamp in 50 years.
Show your clients the stamp example instead of a line graph, and they will get what inflation can do to their nest egg. Revise your visuals by using a card that shows stamps and explains the rise in costs over time. Clients will remember this example even many years later.
Peaks and valleys constitute market averages, and these swings are part of the investment process. Clients instinctively will want to retract from any perception of harm, so they must be reminded occasionally about the stamp inflation example. They must not lose faith in the data.
Explain market averages with this comparison: If you hold a snowball in one hand and a very hot potato in the other, on average you should be feeling normal; however, you would not be very comfortable. The point is that the equity allocation pursues a long-term average that, at times, will not feel comfortable. But it is during those times that we achieve our highest value for clients if they recognize that these swings are normal. We trust long-term data and that any comfort adjustments or structural changes to clients’ allocations are best done when the market is stable, not under duress when markets are volatile.
A staircase is another image you can use to help clients focus on the long-term perspective. The staircase represents the long-term market performance. Next, visualize a person walking up those same stairs while playing with a yo-yo. The yo-yo moving up and down represents the short-term swings in the market. We all should focus on the staircase, giving little, if any, attention to the yo-yo. This illustration is a great reminder for a client who gets nervous during a down market or the crisis du jour.
As advisors, we must remind our clients that the greatest long-term risk of the equities markets is not the dips and corrections. The greatest risk is not being in them.