Inflation is the rise in the price of goods and services over time. Your spending power will erode if you fail to account for inflation in your financial plan. For example, an investment portfolio weighted too heavily in favor of low-growth, low-risk investments is vulnerable to inflation.

To illustrate, if Bev invests $10,000 in a certificate of deposit (“CD”) paying 5% interest, compounded annually, she will earn $500 in interest in her first year. If Bev is in the 28% tax bracket and we assume an inflation rate of 5%, she actually lost ground financially. She paid $140 in income taxes ($500 X .28 = $140) resulting in $360 (the original $500 interest less the $140 owed for taxes) of “net investment income.” Now consider that Bev’s initial investment of $10,000 is not actually worth $10,000 in today’s dollars due to inflation. Assuming a 5% inflation rate, Bev would actually need $10,500 to have the same spending power as she did one year earlier. Since her portfolio grew by only $360, Bev actually had a real rate of return of a negative 1.40% after taxes and inflation. Her income and portfolio are growing, but the cost of goods and services is growing at a faster rate. Bev is slowly losing ground.

INVESTMENT RISK

It is often thought that as risk increases, so does return. Actually, higher risk gives the potential for higher returns, but it also creates the potential for higher losses. That is not to say that higher risk investments such as individual stocks do not have a place in your portfolio. Historically, stocks and other “equities” (see below) have out-performed all other investments, earning a rate of return in excess of ten percent. Since low risk investments rarely offer even the potential for high returns, you cannot achieve diversification without some amount of risk. The key is to determine the level of risk you can live with.

Everyone’s risk tolerance is different. Your risk sensitivity may be quite different from your late spouse’s, and may have changed since your spouse’s death. The key is to achieve the rate of return to meet your short-term and long-term goals, without incurring a level of risk that keeps you up at night.

DIVERSIFICATION

The most effective way to minimize investment risk (including the risk of inflation) is to diversify your investments. By combining different investments you can insulate your portfolio from fluctuations within asset types. The benefits of diversification are illustrated by the following comparison of two portfolios. The first is diversified, containing 50% stocks and 50% cash (e.g. CDs and Treasury bills).

The second is non-diversified, with the entire 100% invested in stocks. Each portfolio will invest $100,000 for two years. In the first year, the market grows by 20% while the going interest rate is 5%. In the second year, the market declines by 20% while the going interest rate stays constant at 5%.

Let’s compare the two strategies and see what happens:

Despite a stock market downturn of 20 percent in Year 2, the diversified portfolio lost only 7.5 percent. The non-diversified portfolio lost the full 20 percent.

TAX CONSIDERATIONS

Income tax must be factored into your financial plan. Distributions from IRAs (other than Roth IRAs), and 401(k)s are fully taxable. The interest on municipal bonds is tax-free. Annuity payments are part taxable and part tax-free. The portion of the annuity payment reflecting your “investment in the contract” is tax-free, while the portion representing growth on your investment is taxable as ordinary income (see more about annuities in this chapter).

YOUR FINANCIAL PLAN

Your financial advisor will develop a financial plan taking into consideration your net worth, income needs, risk tolerance and future goals. The plan should contain specific investment recommendations. Depending on how you are invested, some of your investments will need to be converted to fit with your plan. Life insurance proceeds and any retirement distributions received by you on account of your spouse’s death (whether or not they were rolled over into your own IRA) will likewise be invested according to your plan.

To implement your plan, you and your advisor will choose a diversified mix of the various investment options described below in “Understanding Investments.” Once your plan is in place, you should meet with your investment advisor no less than annually to assess your changing needs as well as changes in the market.

Future investment choices will be made based on the quality of the investment under consideration as well as whether it’s consistent with your financial plan. With your financial plan in place, you are the captain of your ship tacking your way to your destination. Following your financial plan will minimize the risk of market downturns and allow you to live the life you have chosen for yourself.

With a plan, you are better able to resist the temptation to purchase the investment du jour or “time” the market based on the headlines in the morning paper or a television commentator’s financial outlook. The daily news is a snapshot of current events that naturally distorts the long-term view of investing. History has proven that market timing is nearly impossible, and should definitely be avoided.

The following chart illustrates the remarkable opportunities lost if you were out of the market on some of the highest-rising market days of the past decade:

The message is clear. Chart a course and a plan and stick to it. Review your plan regularly, but not less than annually and adjust your plan as needed to account for changes in the market and your life.