Consider Inflation When Building Your Portfolio

(MoneyWatch)  There's an interesting statistic in an article in today's Wall Street Journal discussing whether stocks should dominate investors' portfolios. In challenging the "stocks for the long term" view, one of the points made in the article was that in the past 50 years, the best year for stocks (1975) was a 37 percent return, but the worst year (2008) meant a 37 percent decline. For bonds, the best year (1982) meant a 36 percent return, while the worst year (1999) resulted in a 6 percent decline.

As we've discussed before, looking solely at returns when determining an asset class's role in your portfolio is a mistake. Another consideration is the potential effect of inflation on the portfolio. Consider the following.

Stocks and Inflation
For the 10-year period ending February 2009, stocks (as measured by the CRSP 1-10 total market index) lost a total of 22.0 percent. Since cumulative inflation was 29.0 percent, the real total return to stocks was negative 51 percent. That's also why the bear market we just experienced seems so painful. The real loss is far greater than the nominal loss.

Bonds and Inflation
However, for the 10-year period ending February 1951, one-month T-bills (considered a riskless investment) produced a total return of 5.6 percent, while we also experienced total inflation of 62.8 percent. That means those avoiding the risk of stocks lost more than 57 percent in real terms, or greater than the worst 10-year real loss for U.S. stocks.

The lesson we take from the historical evidence is that those seeking to avoid investment risk may incur the even greater risk of the loss of their purchasing power over the long term. The bottom line is that in terms of achieving financial goals, the return from riskless instruments may likely to prove insufficient.

Most investors need to take some investment risk. How much risk you need to take depends on the rate of return needed to achieve your goals -- generally speaking, the higher the goal, the greater the equity allocation. A good financial advisor can help you determine the most appropriate allocation for you, based not only on your need to take risk, but also your ability and willingness to take risk.