This article was originally published on ETFTrends.com.
In short, inflation is when the prices of goods and services rises over time, which means the “purchasing power” of your money is falling. A Big Mac may be priced at about $4.00 today. But if the cost of the Big Mac ingredients (beef, flour, lettuce, etc.) and the labor (hourly wages) to make the Big Mac go up by 3% a year (for example), the price of a Big Mac may be $4.15 next year. It’s the exact same Big Mac, but next year you might need an extra $0.15 to buy it. Your $4.00 can’t buy quite as much as it used to; it’s “purchasing power” has gone down.
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The inflation problem
An extra $0.15 for a $4 purchase doesn’t sound particularly alarming, even if you apply it to every purchase you make next year. But the problem becomes more apparent if you start to consider the compounding of annual price increases over many years. I’ve already established that successful investing is a long-term endeavor, involving a few years for bond investing and at least 5 to 10 years for stock investing.
Over these time spans, the dreamy miracle of compounding returns turns into a nightmare when it comes time to spend those returns on something in the real world. As shown in this graph, all the while your investments are compounding, so are the prices of goods and services thanks to inflation. And the longer compounding works, the greater the increases in both returns and prices.
In this example, if you had invested $1 in government bonds in 1926, you’d have about $23 now (red line). But during that same 90 years, something that was priced at $1 in 1926 is now priced at about $13 today (gray shading). In other words, you could buy almost three pounds of cheese for one dollar in 1926, while today you need around $5 to buy just one pound of the same cheese.
Well, not the exact same cheese, because that would be incredibly hard and moldy by now. That 23 times increase in your bond value is a mere 1.8 times increase when the declining value of a dollar is factored into the analysis. Taking more than 90 years to only double your money seems like a pretty dismal investment plan. How can we do better?
Inflation and investing
I’ve already talked about how inflation impacts specific investments. For example, in Article 6.2 I noted that most estimates point to a future 4 to 6% annual average return for stocks on a non-inflation adjusted basis, and more like 2 to 4% when inflation is considered. A couple of percent difference between nominal and real return may not sound like a lot, but it has a huge effect over time. Here’s a graph I created using Robert Shiller’s data comparing compound returns in the S&P 500 on nominal and inflation adjusted real basis (orange and gray lines). The yellow bars show how inflation varied over time and contributed to the divergence of nominal and real returns.
The idea of turning 1$ into almost $320,000 sounds a lot more compelling than the bond growth scenario discussed above. But again, the real result is closer to only $17,000 when the purchasing power of those dollars is considered. That’s $303,000 dollars in potential return vaporized because of inflation.
This graph also illustrates that when inflation is sporadic or negative (called deflation), like it often was from 1871 to about 1931, the nominal and real stock returns aren’t that different. When inflation is consistently positive, like 1940 to today, the nominal and real return lines diverge rapidly. In real terms, stock performance over time can be mostly explained by inflation rates alone, even if you regard yourself as a particularly good stock picker.
Media articles often assert that inflation makes bonds a “bad” investment or cash a “terrible” investment. One of the most important points that is often left unmentioned is that inflation impacts all investments essentially equally. It doesn’t matter whether a $10 investment return came from stocks, bonds, or even cash.
The value of that $10 is still the same, and that value is always less than it was 5, 10, or 20 years ago, regardless of how you obtained it. The real question of importance is not how the money was invested, but how long it took to generate that $10 return. That’s because inflation was constantly eroding the value of each dollar over time regardless of the investment vehicle.
If you like to think in mathematical terms, the “Fisher” equation for calculating real (inflation adjusted) returns makes it completely clear that all investments are effected equally by inflation.
In this case, RN is the nominal (non-inflation adjusted return) and RI is the inflation rate. The exact same equation is used for stock, bond, and cash returns. You can plug-in the inflation rate and annual nominal return for any investment and get RR, the real (inflation adjusted) return. So, if your stocks returned 8% last year, and the inflation rate in that year was 3%, your real rate of return was 4.854%. You’ll note that 4.854% is approximately equivalent to just taking 8% (the nominal return) minus 3% (inflation rate), which equals 5% (the approximate real return). People often use this simple subtraction method to obtain a quick estimate of the real return.
This table provides both the exact and quick estimates of real returns using a 2% annual inflation rate and expected future nominal returns for stocks, bonds, and cash.
InvestmentNominal Expected ReturnReal Expected Return Fisher EquationReal Expected Return Quick Estimate (RN-RI)Stocks5.0%2.94%3.0%10 Year Bond2.3%0.29%0.3%Cash1.2%-0.78%-0.8%
Inflation takes the same 2% bite out of every investment type. No return is entirely safe, and no return does “better” than the others at avoiding this inflation bite. If you pick investments that produce returns lower than inflation, then you will lose money in real terms. If you pick investments that produce returns higher than inflation, then you will make money in real terms. It’s really that simple.
The major caveat, as we’ve seen in prior articles in this series, is that inflation is only one of many mechanisms that can decrease your investment returns. A stock market crash is another mechanism I’ve copiously discussed. So, saying “cash” is a terrible investment because of inflation, completely ignores the other risks involved in holding stocks and bonds. , Having a cash reserve in your overall investment portfolio that is spent over a several year time frame is a “good” investment strategy under the correct circumstances.
Another thing you will often hear from the media and professional advisers is talk about inflation “risk”. I discussed in Article 4.3 that the term “risk” is loosely used in different ways and with different meanings. Risk is often misunderstood as a concept, and therefore, the term is overused and even abused.
The assessment of risk, and the subsequent concept of risk management, was born out of the nuclear power and space exploration industries. In this context, a risk is not anything bad that you can imagine, but rather, it is an uncertain or infrequent event that could cause substantial harm.
For example, a space rocket designer might want to consider the risk of a one-time failure in a specific reusable rocket booster seal, which was the cause of the Challenger space shuttle disaster in 1986. In the investing world, a similar type of risk might be subprime mortgage lending practices leading to a stock market crash in 2008.
In contrast to a classic risk factor like a rocket seal failure, inflation is a predictable and more or less continual process that impacts all investments equally. The last graph shown above makes it clear that, particularly since the 1940s and the development of modern monetary policies, inflation has occurred continually with some variation in magnitude. In this sense, inflation is not a classic risk factor, and is poorly addressed through risk management. Inflation is more like the expected corrosion in a rocket booster nozzle over time.
In cases like these, engineers know the nozzle materials they use will corrode and degrade after repeated usage, and they know that no material is entirely immune to this process. So, instead of treating these continual processes as uncertain risks, engineers build in operations and maintenance procedures to track, minimize, replace, and correct material degradation problems before a disaster occurs. For an investor, inflation is much more of an operations and maintenance problem than an uncertain “risk”.
There is no “risk” of inflation, because the continued existence of inflation (or deflation) is a near certainty. The only time it probably makes sense to talk about inflation “risks” is when considering the possibility of sudden and large changes in the inflation rate. One example of an inflation risk might include a rapid swing from inflation to deflation as occurred multiple times in prior to the 1920s.
Another example might be a sudden large increase in inflation from moderate to extreme levels as occurred in the 1970s. These unexpected and infrequent swings in inflation should be considered when in investing, because they may seriously impact your portfolio.
Mindful investing for true inflation risk
To guard against true inflation risks (rapid and unexpected swings in inflation rates), we need to look at the history of inflation versus stock, bond, and cash returns. History is never going to predict the future exactly, but it’s often some of the best empirical data available.
Bonds – This graph compares the 10-year bond yield (blue line) and Federal Fund Rate (FFR; redline) to inflation rates since 1960. The FFR is a reasonable proxy for cash interest rates, such as a 6-month certificate of deposit.
Essentially, bonds (and cash) yields go up and down with inflation. This is because nobody wants to put their money in a “safe” investment just to find out they lost money in real terms at the end of the process. As discussed in Article 6.2, rising inflation usually causes higher bond yields but lowers bond prices. The cumulative effect is that bond returns suffer during inflation increases. However, even in this situation bonds almost always provide a positive return (if held for their duration) because bond yields and inflation rise together.
Sudden decreases in inflation usually cause the opposite reaction, where bond yields decline and prices increase. Declining inflation more clearly favors bonds as prices increase on bonds that have favorable current yields. This is the process that drove the great bond bull market from the 1980s to present.
This is not to say that bonds are a perfect hedge against rapid changes in inflation. There are certainly shorter historical periods where bonds did very poorly. But as this graph from Article 8.3 again illustrates, bonds have usually been a safe (albeit unspectacular) investment over huge ranges of inflation conditions and fluctuations.
And as I pointed out in Article 8.3, if you hold bonds for their duration, history indicates that you’ll rarely lose significant real value over time.
Cash – The story of cash and inflation is similar, but not exactly the same as the bond story. I established in Article 7.3 that cash should be a short-term investment. This is because, regardless of whether you factor in inflation or not, cash generally provides a poor return. Cash interest rates will move up and down with inflation as shown above. So, over the short-term, it’s rare that you will have huge real losses in an interest-bearing cash account or short-term CD due to inflation changes.
For example, if inflation rises rapidly this year and your low-interest 6-month CD matures, you can usually plow that money back into another 6-month CD offering a higher interest rate. Regardless, over longer periods, you will get better returns from bonds and stocks. But there are times, like right now, where cash is nearly as good as bonds, and can be used just as effectively as bonds for the short-term ballast portion of your portfolio (as discussed more in Articles 7.3 and 8.3).
Bonds, cash, and true inflation risk – This information on bonds and cash gives us new insight into how to manage the true risk related to inflation, which is rapid and unexpected changes in inflation rates. For example, if inflation did suddenly and unexpectedly flare up next year, our mindful conclusions about using cash instead of bonds for short-term ballast would likely be entirely different in that environment. For example, as shown in the graph at the start of this “bonds and cash” section, investing in a constant maturity 10-year T-bond fund in 1982 (if such a thing existed then), would have been a phenomenally good idea.
That’s because the 10-year T-bond yield levitated 2% to 8%(!) above the rate of inflation for 20 years until about 2005. That’s why I said in Articles 7.3 and 8.4, that investing in intermediate bonds probably doesn’t make sense until the bond yield is about 2% above the inflation rate.
I also discussed in Article 8.3 that Treasury Inflation Protected Securities (TIPS) bonds are likely to provide a particularly good hedge against the true risk of unexpected inflation rate increases. TIPS provide this inflation protection by adjusting the principal and interest rates of a regular U.S. Treasury bond by the annual inflation rate, measured by the Consumer Price Index (CPI). TIPS will typically outperform similar duration Treasury bonds when inflation is positive, and under-perform T-bonds during deflation.
Stocks – Unlike bonds and cash, stock returns are not clearly correlated with inflation, as shown in this graph I created using changes in the Consumer Price Index (CPI) and nominal S&P 500 returns from Robert Shiller’s data.
Importantly, stocks provided positive nominal returns in many times when inflation was both positive and negative, even strongly so. This tells us that stocks can do well in times of inflation and deflation, but the primary risk we are concerned with are sudden changes in inflation rates. So, I broke these data down even further and examined just stock returns in the same years when inflation rates changed more than 4% (either up or down).
And given that stock reactions may not be instantaneous with inflation changes, I looked at the next year’s stock returns as well.
Mindful investing for routine inflation
For routine ongoing inflation, a mindful perspective takes us back to the simple determination that you want to invest in assets that provide returns beyond the expected rate of inflation. As shown in the above table, stocks are currently the only one of the three major asset classes (stocks, bonds, and cash) expected to have significant positive real returns. Thus, a stock heavy portfolio appears prudent for most investors right now. This is another way of expressing the same mindful conclusion we reached in the Article 7 series. This conclusion remains true considering the other risks associated with stocks, which I defined in prior articles as not routine volatility, but the relatively moderate risks of permanent losses over a long-term investing time frame.
This graph of S&P 500 nominal return data minus the CPI inflation rate (the virtual definition of real returns) illustrates this conclusion. That is, nominal stock returns tend to outpace inflation in most years, although there are certainly lots of exceptions.
We can further confirm the conclusion of “stocks over bonds” for investing in most inflation periods by looking at the real returns of long-term treasury bonds versus the total U.S. stock market starting at the unprecedented and long-lived bond bull market starting in 1982. This graph from Portfolio Visualizer presents the comparison with stocks shown in blue and bonds shown in red.
At many points in this very unusual period (like 1988, 1996, 2003, and 2013) long-term bonds would have proven to be just as good a choice as stocks. But put another way, this also means that stocks were just as good as bonds even under almost ideal conditions for bonds. And as longer-term graphs show (such as the one all the way at the start of this article), at most times, stocks have handily out-performed bonds over wide ranges of inflation conditions and rates of fluctuation.
We’ve determined that:
- Inflation is a persistent aspect of the modern economy and investing environment. Inflation does not preferentially impact one investment type over another.
- To obtain “real” returns our investments must exceed the rate of inflation.
- Right now, stocks are the only investment type likely to substantially exceed the rate of inflation on a consistent basis.
- It’s generally not helpful to think of routine inflation as an investing “risk”. Instead we can plan for and adapt to this persistent part of the investing environment.
- The true “risk” associated with inflation is sudden and unexpected changes in inflation rates (up or down).
- Bonds provide a reasonable hedge against inflation changes if held for their duration. Because rising rate environments provide a drag on standard bond returns, TIPS bonds are a particularly good option to hedge against unexpected inflation increases.
- Held for the short-term, cash provides no practical hedge against inflation changes, but it doesn’t necessarily result in substantial real losses.
- Stock returns and inflation changes are historically uncorrelated. Stocks often have positive returns during rapid inflation changes and provide a substantial, although sporadic, hedge against these changes.
- Stocks have also historically performed better than bonds during most periods of routine inflation and kept pace with bonds during ideal bond environments.
- Our mindful examination of inflation validates the conclusions from previous articles that in most cases, stocks are the best option to deal with routine inflation as well as the more infrequent true risk of rapid unexpected changes in inflation.
- Having a portion of your portfolio in intermediate TIPs may provide an extra hedge against the risk of rapid inflation increases, exactly because such increases are currently unexpected.
- Finally, cash can be a valid substitute for bonds as portfolio ballast, but only if held for relatively short periods. Inflation and interest rate changes should be closely monitored by the individual investor now and always. Such rate changes will likely require a re-evaluation of the asset allocation in your portfolio. For example, if inflation and interest rates increase rapidly soon, it may be prudent to add more bonds to your portfolio or replace cash ballast with intermediate term bonds.
This article was republished with permission from Mindfully Investing.