Inflation, Time Frames & Cash Flow

Dave Sather’s Money Matters

Last week, Warren Buffett published in FORTUNE Magazine an adaptation of his annual shareholder letter. Buffett wrote that bonds “are among the most dangerous of assets,” because of the effect of inflation over the past century—even though bond investors “continued to receive timely payments of interest and principal.” He called them “dangerous” and says they “should come with a warning label.”

Is Buffett crazy? Hasn’t he read a newspaper to see what is going on with Greece and Europe? Buffett isn’t crazy—but it is a matter of perspective on time frames and ability to withstand volatility.

If you invest in a 10 year US Treasury bond today, the government will pay interest of less than 2%–before taxes. After inflation, Buffett knows the Treasury bond is virtually guaranteed of losing purchasing power over the next ten years. For many retirees looking for safe income this presents a difficult predicament.

Does this alone mean that everyone should pile into the stock market? NO!

Over the past fifty years the broad stock market has gained as much as 57% in one year and lost as much as 37%–that is a huge swing. But it is a short term swing—and Buffett knows that. And therein lies the issue—smart investors must match investment needs against time frames.

The only time you should consider investing in the stock market is if you have truly long term (10+ year) time frames. If you need money for your child’s tuition next semester then do the easy thing–buy a CD or put it in money market.

Many retirees trying to maximize cash flow have turned to the stock market. If that is your choice, proceed, but with caution.

We advise our retired clients not to withdraw more than 4% of their portfolio’s value in a year, but preferably 3%. The 3% number offers odds that your funds are virtually certain to last the remainder of your life. With life spans ever increasing, this is hugely important.

There is one problem with this strategy, however. Assuming a $1 million portfolio, a 4% withdrawal rate leaves you $40,000 to spend. As long as the market is going up, this plan works well. The problem occurs when we revisit another 2008 and the market drops by 40%. All of the sudden your $1 million portfolio is only worth $600,000 and your 4% withdrawal needs to decrease from $40,000 to $26,000. Although many of us think we can make these adjustments, it’s a very difficult trick to pull off—especially in the face of increasing costs of living.

Another method of stretching cash flow is to limit withdrawals to the actual cash produced—the dividends and interest. If a company pays you a $1 dividend with great consistency, then you are not nearly as concerned about the stock’s price volatility. The price might be $30 per share today and $20 tomorrow—all you are concerned with is their ability to consistently pay the dividend.

Given this, smart investors must first identify the time frames over which they are investing. Short term, fixed income investments may be perfect—but over the next 100 years they are a suckers bet due to inflation. Long term, the stock market can deliver better returns, and handsome cash flow, but it comes with tremendous shorter term volatility.