(Mr. Wallace holds NASD Series 7 (General Securities) licenses and Group I and IV Life-Health Insurance Licenses. He is a Registered Representative of MML Investors Securities, Inc., an Investment Advisor Representative of Spectrum Strategies, LLC, and an Investment Advisor Representative and Registered Representative of MML Investors Services, Inc. You may reach him @ ejwallace@finsvcs.com or visit his website at spectrumstrategiesllc.com.)
Diversification as Hedge
Suppose, for example, you have $100,000 invested and you are receiving 10 percent compound interest and think you're doing well. But real rate of return is only relative. If inflation is 6 percent, your real rate of return is just 4 percent (10 percent – 6 percent = 4 percent). The realization that you are receiving only a 4% real rate of return makes most investors take notice.
The fact is that inflation has specific economic causes and those causes often reoccur. Today, some economists are predicting that the higher inflation of the past, may return again. The question is when. Planning a diversified long-term financial strategy is the best way to hedge against the economic erosion of your investments.
The Rule of 72
But, there’s some mathematical shorthand that can provide an even quicker answer. It's called “The Rule of 72.”
To determine approximately how long any amount of money invested on a compound interest basis will take to double, simply divide the interest rate into 72. If you're receiving 10 percent interest, for example, your money will double in 7.2 years: 72 divided by 10 = 7.2.
Compounding interest makes time your ally in wealth-building. But time can be your enemy if general price levels around the country are increasing at a faster rate than your investments. This wealth-eroding element is called inflation.
The Problem of Inflation
Just as compounding builds wealth, inflation destroys it. Compounding interest gives you more dollars, but inflation makes them worth less. Inflation can reduce what you hoped to gain through the use of compounding; however, a smart investment strategy can hedge against it.
When you calculate your return on an investment, be sure you consider the real rate of return, the true measure of your investment's future purchasing power. To find the real rate of return, you must know two things: (1) the gross rate of return and (2) the annual rate of inflation.
The gross rate of return is easy to find. It's the interest you are receiving on your investment plus capital appreciation (or minus capital depreciation). The rate of inflation is measured by the CPI (Consumer Price Index) published by the federal government, although more sophisticated investors tend to follow the WPI (Wholesale Price Index). To find the approximate real rate of return, simply subtract the annual CPI or WPI from the gross rate of return you are receiving. The results might surprise you.
