PRN: Look Out for the Inflation

All finance gurus agree on perhapsone thing: The biggest threat toyour nest egg is not recession, low interestrates, or deflation—it's inflation. Ifyou're too young to remember the lastbig round of it in 1980, when I heard allmanner of things blamed on "the inflation,"or if you've been lulled into asense of false security by Alan Greenspan'salmost preternatural changes ofFederal Reserve interest rates to dampenthe natural economic cycle, let's review.

A Little Review

Inflation is the phenomenon ofincreasing prices for an unchangingamount of goods or services. You don'tget more; you just pay more for thesame thing. The reason boils down todemand increasing faster than supplyto meet the rising demand. More peopleworking, making more money, orfeeling expansive about spending willbid the price of things suddenly in shortsupply up, up, and up. The phenomenoncan be local (eg, real estate), temporary(eg, fads), or, more to the pointof long-term concerns, broad economybasedwhen it grows too fast.

The economy also can be artificiallystimulated by exuberant governmentaldeficit spending. This and other technicaland psychological reasons for inflationwe'll skip for now in the interest ofbrevity and controlled blood pressures.

To give scale to this topic, if you havea $1-million nest egg at even a 3%average rate of inflation, such asrecently seen, in 10 years, without takinga nickel out, you will be reduced to$737,000 in purchasing power. And ifinflation rates increase, our loss in purchasingpower becomes even steeper.It's a big, real problem that investorsignore at their peril.

Coping with Fluxes

If you accept that inflation is a fact ofour economic life, it follows that theproblem for the average physician-investoris the unpredictability of its timingand size. This is one of the fundamentalreasons for diversification. Wegive up the chance for a big gain in anunpredictable inflationary surge for thebenefit of minimizing the big loss wheninflation unpredictably abates to keepour assets moving ahead in real terms.

It stands to reason that if inflationjumps, you want to be invested inthings, not money or bonds, which arethe promise to pay money. That's whyprecious metals and collectibles are thetraditional hedge against the instabilityof inflation. Conversely, gold and thelike add no value when an economy isstable, and lose value when an economyshrinks and cash is king. That'sanother reason why we need to stayinvested in good businesses. Theirstocks can adapt to changing conditionsand grow faster than inflation,which they historically do on average.

The key point, however, is not to gethung up on either a temporary loss orgain in your diversified portfolio, but toalways be moving toward your goals ingeneral, whatever they may be. Hedgefor the ups and the downs. It's not aformula to get rich fast, but it is a formulato get rich slowly.

Jeff Brown, MD, CPE, a practicingphysician who is a partner onthe Stanford University GraduateSchool of Business Alumni ConsultingTeam, teaches in the StanfordSchool of Medicine FamilyPractice Program. He welcomes questions orcomments at jeffebrownmd@aol.com.