The following is a post by MPFJ staff writer, Kevin Mercadante, who is a professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
Any talk about the effects of inflation on investing will move into the realm of precious metals at some point in the discussion. And while precious metals do have a history of responding favorably to periods of high inflation, they tend to languish or even fall during times of low-inflation.
But, if we look at the long-term trend, stocks are your best inflation hedge.
Though that may seem counter-intuitive, there’s plenty of evidence to support the case for stocks as the best long-term inflation hedge.
Stocks Do Well In the Low Inflation Environment That’s More Typical
Over the past 100 years they have been a couple of periods that involved relatively high inflation. Those occurred in the early 1940’s (due to World War II), and the entire decade of the 1970’s. Apart from those two periods, inflation has been pretty tame for the other 85 years.
That’s not a small point, either. When we look at the effects of inflation, we have to consider it in terms of what it does to money that is invested over decades, and not just years. And in most of the low inflationary years, stocks outperformed precious metals.
The best example has been the performance of stocks since the early 1980’s. Inflation has been tame during the entire period, staying mainly below 5% and usually much lower. According to the Bureau of Labor Statistics Inflation Calculator general price levels have increased by about 250% since 1982. But during that time frame, stocks have risen from a low of Dow 800, to the current level of nearly 18,000. That’s an increase of more than 2,200%.
That performance has more than overcome the stagnation that stocks experienced between 1970 and 1982. If you were a young person saving and investing for retirement since and during the 1970’s and early 1980’s, you would have done much better on the inflation front investing in stocks than just about any other asset class.
Commodities Aren’t the Inflation Hedges That We Assume Them to Be
There’s no question that commodities performed very well during the 1970’s, certainly much better than stocks. But looking at the same time frame used above, gold averaged roughly $400 an ounce in 1982. It currently trades at about $1,200, which is to say that it’s 300% higher than it was in 1982.
Now to be sure, gold has acted as a true inflation hedge, increasing by 300% while general price levels increased by 250%. But it didn’t do much more than keep up. Compare gold’s 300% price increase with the 2,200% increase in stocks (as measured by the Dow), and decide which has been the better inflation hedge.
We have to remember that inflation isn’t marked just by the times when it is particularly high. When you’re investing for the long run, you have to account for inflation over the course of your lifetime. When viewed from that angle, stocks are the better inflation hedge.
Bonds Are a Guaranteed Money Loser to Inflation
Whether stocks or commodities are a better inflation hedge, one thing is certain: bonds are an inflation train wreck. Probably no investment security is more vulnerable to inflation than bonds.
Here’s why…
Bonds are priced at a specific amount, say $1,000. They also carry a fixed interest rate, say 3%. If inflation rises and causes bond rates to rise to 4%, the value of the bond will fall. The reason that it will fall is so that its price drops low enough that the yield on its market value will produce a 4% return to match market level returns.
If you bought a 30 year bond for $1,000 at 3% ($30 per year), and rates increased to 4%, the value of the bond would have to fall to $750 to support a 4% yield ($30 divided by $750 equals 4%).
Inflation is the primary factor driving higher interest rates. When inflation rises, so do interest rates – and that causes bond prices fall.
Translation: Bonds are not an inflation hedge. They’re more of a classic inflation victim.
Real Estate is a Good Inflation Hedge – But Stocks are Easier
Much like stocks, real estate can be an excellent inflation hedge. This is true not the least of which because it can be easily leveraged For example, if you can buy a property for $200,000 with a 20% down payment (plus a $160,000 mortgage), and the value of the house doubles to $400,000 in 20 years, you will get a 600% return on your investment.
You put $40,000 down on the property ($200,000 X 20%), and you’re equity grows from $40,000 to $240,000 (the $400,000 current value, less the original mortgage of $160,000). The calculation becomes even more impressive if you factor in the pay down on your mortgage.
So far so good. But real estate is not necessarily an easy investment, and that’s true whether it is an investment property or the home that you live in. You will pay real estate taxes, insurance, and utilities, as well as the costs to maintain, repair, and upgrade the property over those 20 years.
None of those complications exist with stocks. You invest your money with only very small costs (transaction fees and investment expenses), and because your investments are highly liquid, you can move in and out of them virtually any time that you want.
Real estate may be as effective as stocks as an inflation hedge over the long-term, but stocks are the easier solution. This is even more true when you consider that real estate goes through periods of illiquidity, when it is close to impossible to sell out at any price. That’s never true for stocks, or at least hasn’t been up to this point.
The Track Record of Stocks Speaks for Itself
When you look at the track record of stocks, it’s hard to argue against them on any level. The historic rate of return on stocks as measured by the S&P 500 is somewhere between 9.60% (geometric) and 11.53% (arithmetic) for the period from 1928 through 2014. Either is an impressive number, especially when you consider that it covers 86 years.
That time frame includes periods of growth, inflation, depression (deflation), wars and political crises. That’s the precise type of investment that you want to be in for the long-term, and certainly for retirement planning.
Different Stocks for Different Inflationary Environments
There’s one other aspect of stocks in regard to inflation that doesn’t get much coverage. Unlike most other investments, stocks are highly segmented. That means that the potential exists to hold stocks even during periods of high inflation, and still come out ahead.
You can do this by investing a larger percentage of your portfolio into sectors that specifically benefit from inflation. This can include stocks and funds that are invested in precious metals, energy, food, and other commodities. This kind of investment strategy can enable you to continue earning outsized returns even during a period of inflation that may not be beneficial to the stock market in general.
So in the event that high inflation returns, you don’t need to dump your stocks – you’ll just have to shift the allocations to take advantage of the new trend.
How about you all? What do you utilize in your investing portfolio for hedging your bets against inflation?
Share your experiences by commenting below!
***Photo courtesy of https://www.flickr.com/photos/101332430@N03/9681099086/in/
