The Flaw of Average Inflation
Imagine you’re a quarterback passing the ball to an open receiver. The first throw sails five yards past. The next play, you throw it five yards short. Most people would call you a lousy quarterback, but the mathematician in the audience would say your performance was perfectly average.
In the 1940s, the U.S. Military was struggling to understand why so many of its newer, faster, jet-age planes were crashing. The frequency was an anomaly, and crashes were happening across various plane models. If it wasn’t the planes, perhaps it was the pilots? So in 1950, they commissioned a study of 4,000 pilots on 140 dimensions of size, from the length and width of thighs to the length of their thumbs. No measurement went undocumented. It was believed a better-fitting cockpit would lead to improved comfort and performance for the pilots. They took all these measurements, found the average for each, and then affixed the seat and waited for results.
Meanwhile, one 23-year-old newly hired scientist named Lieutenant Gilbert Daniels had his doubts. Just how many pilots were “average,” he wondered. Digging into the numbers, he found that not a single pilot of the 4,000 fit the “average” for which the new cabins had been designed. Some had longer legs, and shorter torsos. Some had wider chests and shorter arms. Even reducing the 140 points of measurement to only three chosen at random suggested that only about 3.5% of the pilots would fit the “average” for which the seats had been designed.
In short, no one was average.
Eventually, the military would change their approach, adding adjustable seats, belts, pedals, and other items that helped customize the fit for the pilot. As a result, the rate of crashes declined. Lieutenant Daniels had stumbled upon what is now referred to as the flaw of averages.
The flaw of averages is the idea that plans made based on average assumptions are wrong on average. As an example, think about the statistician that drowned while crossing a river that was, on average, three feet deep.
This month, the inflation rate hit a 40-year high of 7.5 percent nationally. Though many seemed surprised by the high number, it wasn’t surprising to anyone who’s been to a grocery store recently. Or anyone who has purchased a car, home, medical care, or subscribes to Netflix. In Colorado and other mountain states, including Arizona and Wyoming, the inflation rate topped 9 percent according to Bloomberg.
Inflation exists all around us and has only recently come to the forefront of the discussion for one simple reason: It’s not a few things getting expensive anymore; it’s everything. Or at least it feels that way. But like our stories above, it’s important not to get caught up in the averages.
The Federal Reserve measures inflation using the Consumer Price Index or CPI. The CPI is a theoretical “basket of goods and services” that is supposed to simulate the prices paid by an “average consumer” for things like housing, apples, cell phone bills, and gasoline. When they say inflation is at 7.5 percent, they mean that the combined prices of those goods and services have risen by a total of 7.5 percent over the past year. The challenge, of course, is determining what is “average.” A consumer in Kansas is going to pay a different price for a gallon of milk than a person in New York. A senior is likely to require significantly more medical care than someone in their early 20s. Even something as universal as gas prices will vary based on location, vehicle choice, amount of driving, and so on.
My point is this: there is no such thing as an “average” inflation rate. Instead, each of us will have our own personal inflation rate based on the variables within our own lives.
Consider one large item used to determine the CPI – housing costs. For anyone in the Denver area, it’s not surprising to see the value of your home on the rise as of late, probably by a significant amount. Yet this rising home value has little effect on the cost of housing for those who own their homes. Sure, property taxes have increased, as have the costs of maintaining a home, but the actual mortgage probably hasn’t budged. With mortgage rates so low and the availability of refinancing, the past few years have probably been deflationary for most homeowners, allowing them to reduce their mortgage interest and monthly payments.
Now compare that experience to someone renting. It’s not uncommon today to hear rent prices jumping by as much as 25 percent over the previous year. Combine this with a high-priced housing market, and you have a perfect storm of folks who can’t afford to buy and can no longer afford to rent. With the Federal Reserve promising rate hikes soon, it’s likely that any cooling in the housing market will be balanced out by an increase in mortgage interest rate costs. Inflation has reared its ugly head.
Likewise, the cost of education doesn’t affect those who generally already have one. But the inflation rate for higher education surpasses the “average” by over 5 percent per year, averaging about 8 percent, according to finaid.org. At that inflation rate, the cost of tuition doubles every nine years. If you had a child recently, you should expect their tuition to roughly cost about four times what it does today by the time they head off to school.
The reality is that the average inflation rate is largely meaningless to most Americans. Your personal inflation rate may be above or below 7.5 percent. Instead, the message worth receiving is that everything in life continues to get more expensive over time. That’s why we believe “fixed income” investments are a bad bet for investors. The very definition of fixed income offsets the blessing of their reduced volatility: it’s fixed. It doesn’t move up or down. So as everything gets more expensive, the purchasing power of your money in bonds or other fixed-income investments shrinks.
Volatility is the price we pay for an income that grows with inflation. Enduring the wiggles is what it costs to prevent your purchasing power from shrinking over time.
Inflation will impact all of us differently. However, planning for an “average” inflation simply does not account for the variability in the goods and services you purchase. That’s why it’s so important to have a plan that considers your specific needs. Without a personalized plan, you’ll be climbing into an average cockpit, and I bet it won’t be comfortable.