Defined as those born from 1965 to 1980 and sandwiched between the Baby Boomers and the millennials, Generation X is a unique demographic segment. Unlike previous generations, Generation X hasn’t had to navigate a prolonged period of high inflation as adults.
While some older Gen Xers may recall the stagflation era of the 1970s as children, most members of Generation X are probably experiencing an inflation spike as adults for the first time. Accordingly, if you’re a member of Gen X, especially one on the cusp of retirement, then it’s important to ensure that you’re approaching these inflationary times in an informed manner.
Falling Victim to the Money Illusion: The Inflation “Tax”
How well do you take inflation into account when making financial decisions? Many investors routinely ignore the impact of inflation, which measures the rise in prices for goods and services over time. Without accounting for inflation, you could be falling victim to the money illusion. The money illusion is when people view their wealth in nominal-dollar terms instead of real terms that equate to purchasing power. This phenomenon can lead investors to invest too conservatively by failing to account for the detrimental effects of inflation over time. Inflation in the U.S. has generally been incremental and gradual. While there have been periods when inflation suddenly spiked, inflation in the U.S. has averaged about 3% per year over long periods.
Inflation can act as a tax because rising prices erode purchasing power over time. As time passes, the real value of money declines. The best way for Gen X to counteract, or hedge, against inflation is to invest your money so it can grow. Keeping money in a bank account or money market fund simply won’t generate enough return for your money to keep pace with rising price levels.
Consider this example:
An investor has $20,000 to invest. Investing in a broadly diversified stock market index would grow that sum to over $93,000 in 20 years if returns average 8% per year.
Investing the sum in bonds, assuming an average annual return of 4%, would equate to only about $43,800 over the same period.
On the surface, turning a $20,000 investment into $43,800 may seem like an acceptable outcome, but once inflation is accounted for, the results look very different.
Inflation that averages 3% per year means that $20,000 earning a 4% return would grow only 1% per year in real terms, equating to just $24,400 in current purchasing power 20 years later.
That same $20,000 invested for 20 years in a stock market index that averages an 8% annualized return with 3% inflation would grow to approximately $53,000 in current purchasing power. 1
Ultimately, the bond investment would yield an increase of only $4,400 in purchasing power over 20 years. That doesn’t necessarily mean that it’s a poor investment for Gen X — some investors may have financial goals other than growing their wealth. Most investors, however, need to grow their wealth in real terms to achieve their financial goals.
Beware the Pitfalls of Holding Too Much Cash
Many investors today tend to look favorably upon bank accounts, Certificates of Deposits (CDs) and money market funds since yields have risen significantly from all-time lows. However, interest rates and inflation tend to increase together.
Inflation isn’t the only thing working against growth. Taxes take another bite out of nominal returns, with yield from taxable bonds and cash equivalents typically taxed at ordinary income rates.
Properly managed stock market exposure, however, is typically taxed at long-term capital gains rates, which are significantly lower than ordinary income tax rates for many investors.
The Importance of Allocating Assets According to Financial Goals
While there are good reasons to incorporate bank accounts, CDs and money market funds into a financial plan as emergency funds and short-term savings for Gen X, these cash equivalents do not typically generate the caliber of returns that investors need to grow wealth in real terms.
Gen Xers, particularly those approaching retirement, need to be especially aware of the effects of inflation on their assets. Stock market volatility can be daunting. However, the emotional appeal of holding cash to avoid volatility can be a trap for investors who need to beat the inflation “tax” with prudent investing. Holding excess amounts of cash for extended periods may provide a false sense of comfort and often becomes a losing proposition.
If you’re not familiar with how to balance investment risk and inflation risk, you can work with a CERTIFIED FINANCIAL PLANNER™ professional to set yourself up for financial success.
1. Note that the calculations are performed using a simple approximation for inflation-adjusted returns where inflation-ꟷ adjusted return = rate of return - inflation rate. The actual formula for inflation-adjusted returns is (1 +return)/(1 + inflation rate) - 1.
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