"Inflation Reduces the Value of the Long Term Income Stream Paid by Bonds"
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What is the Number One risk of owning bonds?
In a world of perfect monetary policy, there'd be no inflation.
We could assume that a loaf of bread next week will cost no more than a loaf of bread today -- barring some severe event.
(For instance, bad weather can affect food supplies.)
In fact, in such a world, technological progress over time would actually lower the cost of bread, as we learned how to raise and harvest wheat more efficiently.
Needless to say, we don't live in a world of perfect monetary policy. Ever since the end of World War II and the end of the gold standard, the supply of money in the world has increased more than the supply of goods and services which can be bought with that money.
Which means a general increase in prices -- inflation
Technological progress has actually done a lot to keep inflation down, since it's currently only about 3%, but it can't eliminate it entirely.
During the late 60s to early 80s, inflation in the world was MUCH higher than 3%.
But let's assume it will stay at this historically low level.
At 3% inflation, the purchasing power of a dollar is reduced by half every 24 years.
If you retire at age 65, in 24 years you'll be only 89.
Some of you don't expect to live that long, and many of you will be correct, but it's also true that many of you will be wrong . . . you WILL live that long, and longer.
So if you invest all your money into bonds at age 65, when you're 89 your income will buy only half as much as it did when you stopped working.
That's the danger of bonds -- you get more money upfront (and maybe you'd rather have that when you're 65 and still active rather than at age 89 when you spend all your time just watching TV), but you get less and less spending power as time goes by
However, there is a simply solution -- reinvest a good-sized chunk of the interest you receive. If you reinvest enough of the interest you receive, so that your bond fund is continually paying you an ever-increasing amount of interest which keeps up with inflation, then you have solved this problem.
Of course, you're also failing to spend a lot of the interest you're earning. So you want to make sure that the amount of interest you have left (after taxes) is enough to meet all your living expenses.
So this also means that you should save up more money than you will actually need to meet current living expenses.
You should save up enough money so that you'll always have enough money to reinvest to generate an ever-increasing income through the future.
Next: Interest rate risk.
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