The Consumer Price Index and You - *Ernest Nounou

Last week, in one of the few instances of its relevance for ordinary citizens, the Bureau of Labor Statistics announced the CPI rose at an annualized 4.1%. A Southeastern New England resident, whose cost of living for fuel, food, healthcare, housing, education and other services has risen at least 7% - 8% could legitimately ask, "Only 4.1%?" 4.1% will be the cost of living adjustment for government wages and a benchmark for corporate sector raises. This is ironic, as the BLS does not really consider the CPI a measure of cost of living - see www.bls.gov/cpi/cpifaq.htm.

Once upon a time the CPI was synonymous with cost of living increases and loss of purchasing power. These concepts have now decoupled. Notwithstanding tremendous cost of living increases, government and Wall Street economists claim with a straight face that, based on the "Core CPI" (doesn't include food and energy prices), there's no evidence of inflation in the economy.

Let's accept that the US economy is so large we can extrapolate statistics to support any viewpoint. Let's also accept that calculating a truly representative inflation measure is difficult. Nevertheless the present methodology understates inflation. For example it includes "hedonics" a process that quantifies the quality of the goods and services measured. If a Dell computer with Microsoft software cost slightly more than last year's model but now runs 25% faster and has far more capabilities (whether the average user is even aware of or uses them), the BLS concludes there has been a price decrease in the average cost of computing. But longer waits for technical support and more frequent product breakdowns don't constitute price increases.

4.1% is an average, implying higher numbers in some parts of the US and lower numbers in others. But can anyone name one significantly populated area experiencing lower food, fuel, healthcare, services, and housing costs? Although the CPI seems to be a statistic from a parallel universe, here's what a prudent investor can take from it.

First, the 4.1% CPI underestimates your cost of living and loss of purchasing power. Don't expect the methodology to improve, because that would result in higher cost of living increases and higher interest payments on the public debt. And no one in government wants that.

Second, don't be tempted by sales pitches for bonds or annuities. The 10-year Treasury bond paid 4.49% on October 17, returning .39% above the CPI (4.49% minus 4.1%). If a Southern New Englander used a more realistic 7% cost of living, the 10-year bond would result in a -2.51% loss of purchasing power (4.49% minus 7%), hardly a sound economic decision. Nor would an annuity paying about 6% be that much better.

Third, if you are lucky enough to have savings to invest, common stocks are the most reasonable alternative to achieve returns exceeding your actual cost of living. Here's a specific example: On October 17 Bank of America and other banks were offering 5-year certificates of deposit paying 4.25%. That same day Bank of America (Ticker symbol "BAC") common stock, which pays an annual dividend of $2.00, closed at $41.57 to yield 4.81%. Note that $2.00 dividend is taxed at a lower rate than interest from CDs, bonds and annuities, an important advantage for common stocks.

BAC has a history of increasing its dividend by 15% to 20% every year. Assuming an annual increase of 15%, by the 5th year the original $2.00 dividend grows to $3.49, resulting in a yielding over 8.0% on your original investment ($3.49/$41.57). And assuming BAC's share price increases by a modest 2 points on average every year, by the 5th year the price would be at least $51.57, a 24.06% appreciation - clearly a better reward and preservation of purchasing power, for only a slightly higher risk.

It is financial dogma that as retirement nears; one's portfolio mix should evolve in favor of more bonds and annuities. But a retiree on fixed income has similar cost of living concerns. For a time horizon of greater than 4 or 5 years, conservatively priced dividend paying common stocks are actually a more prudent way to go.

In summary as your cost of living continues to increase at annual rates in excess of 7%, it makes little sense to make long term investments in CDs, bonds or annuity instruments. They simply fail to pay enough to compensate for your annual loss of purchasing power. Quality common stocks - paying attractive dividends that enjoy more favorable tax treatment, and will likely provide returns in excess of your cost of living - is the wisest way to invest for the long term.

*A graduate of Wharton, Ernie is a Founding Partner of Catalytic Group, Inc., a Technology consulting and execution firm. A former banker he enjoys writing on business topics and can be reached at ernie@catalyticgroup.com.