Ask The Expert with Larry Swedroe, January 2009 Issue

By Larry Swedroe, on December 30, 2008

This is the 12th issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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Question from Rich:

In reference to the November issue, how will TIPS fare with the recent and massive increases in the money supply (i.e. inflation)? Also, the CPI doesn’t match my or others real experience, living costs seem much higher than what the CPI tells us. Do TIPS really keep up with real inflation?

The most important thing to remember is that TIPS provide a guaranteed real return. While this might be a bit complex for some here is the explanation.

The return cannot be less than the real yield to maturity (YTM) at the time of purchase. Remember though that there is a difference between the coupon and the yield to maturity. If you buy a TIPS with a 2% coupon and pay above (below) par the YTM will be less (more) than the coupon. You also need to understand that the inflation factor is not paid in the form of interest. Instead, it is added to the principal, this adjustment is called the inflation factor. If you have a positive (negative) CPI, the inflation factor rises (falls). Thus, it is possible that you can buy a TIPS with an inflation factor of say 110 and have that inflation factor fall, reducing your NOMINAL (but not real) return.

However, TIPS have a unique feature that is very valuable: They cannot mature at less than par (100). That means that if you purchased a TIPS with an inflation factor of 110 and from that point until maturity the inflation factor was a negative 20%, the TIPS would not mature at 90, but 100. Thus the real cumulative return would be greater than the YTM at the time of purchase, with the difference being that 10% cumulative deflation in excess of the inflation factor.

It is very important that investors understand that the only returns that really matter are REAL returns, as you cannot spend nominal dollars. Unfortunately, many people are fooled by what I call the “money illusion.” Consider the following simple example. Which return would you rather earn: A 10% nominal return when inflation is 12%, or a 0% return when there is deflation of 5%? The 10% nominal return is actually a negative return of 2% in terms of spending power, while the 0% return is actually a 5% return in terms of spending power. Making it even worse is that you pay taxes on the “phantom” (nominal) income. So in the example of the 10% nominal return and you are in a 30% tax bracket you only earned 7%, or a real return of negative 5%. The lesson is to focus on the REAL return you earn and ignore the nominal return.

The second part of your question focuses on your inflation rate versus the CPI. Some people’s individual inflation rate will be above average and some below. It cannot be that everyone’s inflation rate is above average. For example, if it is housing prices rising rapidly that is driving the CPI up, then those that own homes already will have a lower than average inflation rate. If it is food prices, then those that spend a high percentage of their income on food will have a higher than average inflation rate. It just depends.

Unfortunately, there really is no good way to hedge your unique inflation rate. Your choices still come down to nominal bonds or real bonds, or taking the risk of owning equities. And equities are not a good inflation hedge despite the conventional wisdom. Stocks are far too volatile to hedge inflation. Consider just the last year when stocks fell dramatically but inflation rose. In fact there is a negative correlation between stock returns and inflation, and the longer the horizon, the more negative it becomes (at least out to five years). Stocks have expected returns that are higher than inflation because they are risky assets. But don’t mix the two issues up, a common error. And also note that investments in commodities (e.g., futures contracts) are also too volatile to hedge inflation.

Besides TIPS, there is one other way to hedge the risk of unexpected inflation and that is to have a fixed rate long-term mortgage. If we experienced unexpected inflation interest rates would rise but your mortgage payment would remain fixed. The result is that in real terms the payments would be falling.

If you are interested in learning more about TIPS I recommend you read either my new book The Only Guide to Alternative Investments You’ll Ever Need (which has a chapter on TIPS) or The Only Guide to a Winning Bond Strategy You’ll Ever Need, which also covers TIPS.

Question from Michael:

I’ve been unemployed since June and have a tax question. I already know that because I’m making a lot less this year, I should be able to do a $6K IRA deduction for 2008, as I’m over 50 and my modified adjusted gross income will be under $53K (IRS told me this is valid).

Now, I may want to make changes to my accounts with my financial advisor that will probably give me $11,000 of capital losses by selling a few of my mutual funds. Specifically, in reference to doing a $6k IRA and the deductibility of it, can I still make the total 6K deduction?

I am not a tax expert so I cannot offer tax advice. Having said that I can make a few suggestions/observations for you to discuss with your CPA.

First, if you tax bracket is very low you may not want to take any losses. In fact, you might be in the zero tax bracket for capital gains, which would mean that the losses would have no value to you. Might therefore be better to delay taking them. This is the only time one should delay taking losses. The reason you always want to take any significant loss (especially while it is short term and may be more valuable) is that doing allows you to share the loss with the IRS. If you wait the loss may disappear and the opportunity will be “gone with the wind.”

Second, if you are in a low bracket and have experienced losses in your IRA (if you held any equities there that is almost surely the case) it would be a great time to consider a Roth conversion. You would pay taxes at a low rate on a low amount when you convert and then never pay any taxes again as Roths are not taxable.

Third, with the caveat that I am not a tax expert I don’t see what the $6k IRA deductibility has to do with the capital losses. But your CPA is the one you need to ask that question.

Best wishes to you all for a healthy, happy, peaceful and prosperous New Year.

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Past Issues of Ask The Expert

• 12/2008 - Ask The Expert with Larry Swedroe, December 2008 Issue
• 11/2008 – Ask The Expert with Larry Swedroe, November 2008 Issue
• 09/2008 – Ask The Expert with Larry Swedroe, September 2008 Issue
• 08/2008 – Ask The Expert with Larry Swedroe, August 2008 Issue
• 06/2008 - Ask The Expert with Larry Swedroe, June 2008 Issue
• 05/2008 – Ask The Expert with Larry Swedroe, May 2008 Issue
• 04/2008 - Ask The Expert with Larry Swedroe, April 2008 Issue
• 03/2008 – Ask The Expert with Larry Swedroe, March 2008 Issue
• 02/2008 - Ask The Expert with Larry Swedroe, February 2008 Issue
• 01/2008 – Ask The Expert with Larry Swedroe, January 2008 Issue
• 12/2007 – Ask The Expert with Larry Swedroe, December 2007 Issue

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.

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Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services. Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You'll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You'll Ever Need (2008). Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!

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