According to Inflation Data the average inflation rate for 2011 was 3.16%. This means that $100,000 you have stashed in your bed mattress lost $3,160 in purchasing power. Inflation is effectively a silent wealth tax. Just for holding cash, you lose.
Some of the highest yielding money market account will earn around 1% annually, so if you moved your mattress stash into the banks, you’re still losing to inflation. This is a problem with few solutions that seem suitable for risk adverse investors or people on fixed incomes. Many in retirement have been forced into higher risk investments (stock market) in an effort to increase cash flow. Money in bank accounts are simply losing value.
So what can you do to protect yourself against inflation?
Treasury Inflation Protected Securities, or TIPS are backed by the US government and guaranteed to not lose principal, they are considered risk-free. TIPS pay out twice a year, and the payment is equal to the inflation adjusted principal. They are actually a great way to park cash if inflation is your primary concern, additionally are liquid, although you will forfeit some interest. Another interesting point is since principal is guaranteed, even in a deflationary period, you will not lose principal.
One issue is the rate at which these treasuries pay is tied to the CPI (Consumer Price Index). The CPI excludes food and energy. So as food prices and energy prices rise, these areas would not be factored into the interest payments of TIPS. So to say they complete protection against inflation is debatable. Additionally, if inflation is tame for the foreseeable you simply will not earn any considerable amount of interest.
TIPS are exempt from state tax, which gives it some minor tax advantages over ordinary income.
RE has a strong track record of keeping pace with inflation. It’s rare for real estate to greatly out perform inflation, and when they do, well, you get the Financial Crisis. During the boom we had a situation where home prices became completely decoupled from historical price trends (inflation). Home prices rose much faster than inflation. As result people started to tap into equity created over night to fund lifestyles and economic activity previously not able to be supported with current levels of wage income. A strong case can be made that RE prices will track inflation, and nothing more. Don’t believe me, take a look at this inflation adjusted home price index that goes back to 1970:
Additionally, many real estate growth figures fail to factor in the cost of maintenance, taxes, and other costs associated with keeping property. Real estate investing has hidden risks and ownership costs that many do not account for. However as a vehicle to protect against inflation, RE will do well over the long run.
I’m quickly approaching 2 full years of investing in P2P investing. Although 2 years isn’t long in investing terms, it’s been long enough for me to become comfortable with my expectations in regards to this asset class. My returns have remained above 12% for that period of time, but I am going to assume 10% for this blog post. This presents an interesting situation for those wishing to protect savings against inflation. I am not suggesting by any means you invest all of your money in P2P lending to protect against inflation. But consider this scenario; you want to protect $100,000 of cash against inflation.
You could invest $30,00 of cash in P2P investing to accomplish this. If you placed $30,000 in P2P and earned 10% returns for a year, in addition to $100,000 parked in a bank with 1% yields would earn $4,000 in interest total. The total amount of investment would be $130,000 and earn $4,000 in interest. This would be roughly equal to 3% weighted return, which also equals historical inflation. You’ve just protected $130,000 against inflation. Alternatively could invest $70,000 in a bank yielding 1% and $30,000 in P2P yielding 10%, the return would still be 3%.
Since P2P investing volatility is minuscule compared to the equities market, it becomes a very reliable way to grow and protect principal. In fact, Lending Club has stated that investors with more than 800 notes ($20,000 in P2P lending @ $25 notes) have never lost principal. P2P investing does carry risk, so the situation I have outlined is certainly not guaranteed. It’s wise temper expectations with any investment that carries risk.
Interested in inflation proofing your savings, consider opening a P2P lending account today on Lending Club or Prosper.