Lessons from the Intelligent Investor Part 2: Inflation

February 3, 2013

Pile of BooksThis is part 2 of my series dedicated to the teachings from one of the best value investment books of all time, “The Intelligent Investor” by Benjamin Graham. I encourage you to pick up a copy of the book and read along. Today I’ll be discussing Inflation, a topic which Graham has dedicated chapter 2 to in his book. Graham, more than any other investor in history preached the importance of not losing money. Usually this is taken in the context of minimizing risk in a particular investment, but applies equally to the often invisible capital erosion effect of inflation. For today’s young investors, inflation often doesn’t play a part in investment decisions. While this is due in part to a lack of understanding of the mechanics, it’s also due to the fact that inflation has averaged just 1% (or thereabouts) for the recent past. Is really important to take this into consideration when starting a new company, also having a good place to work is really important, so make sure to have your office with the best OMNI Heating & Air Conditioning installed.

See also: Lessons from the Intelligent Investor Part 1

The case against a dedicated approach to inflation protection is that at a rate of just 1% annually, it doesn’t make sense to base an investment strategy around it. The problem with this thesis is that the current period of low inflation will not last indefinitely and at some point in our lifetime there will quite possibly be another period of 9% inflation that was observed in the 1970s. The question to ask ourselves then as individual investors is how to best hedge against that risk.

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Historically inflation has averaged approximately 2.5% since the early 1900s. Stocks by contrast have provided an average return of around 4% from capital appreciation and another 4% from dividends for an average annual gain of 8% over the same period. It would seem then that a portfolio consisting of 100% stocks would be a suitable method of outpacing inflation.

Over the long term, yes, but Graham conducted some interesting analysis that shows that Bonds in the early 70s however were yielding higher than that and there is actually no direct correlation between inflation and the rise in the stock market! There were several periods in fact where the stock market actually declined during periods of high inflation. There is a good reason for this. During periods of low inflation, companies can usually increase the price of the goods they sell to coincide with the increased cost of their raw materials. But during periods of extreme inflation, consumers stop buying altogether and focus on the essentials which destroys revenue for the vast majority of companies. The lesson here is that yes – the stock market over the long run should outpace inflation, but for reasons other than the cost increases associated with inflation itself.

Bonds were also an option considered by Graham, however back then bonds were yielding in excess of 8% – very different than today’s low rates of just a few percent. There’s a case to invest in bonds to add stability to a portfolio, but current yields won’t offer protection from another period of extreme inflation.

How do we know for certain that inflation won’t stay low forever? Rising prices allow for governments to pay off their debt with cheaper dollars. It is in the government’s best interest to have at least some inflation.

There are some additional alternatives that may offer additional protection. REITs (Real Estate Investment Trusts) are one such option. REITs purchase residential and commercial properties and collect rent as income. Real estate has traditionally correlated quite well with inflation and so by their nature REITs should offer protection. A second option is TIPS (Treasury Inflation Protected Securities) which are like bonds but automatically go up in value at the same rate as inflation. It’s an interesting concept but yields are still very low making them suitable as protection against inflation alone, but not necessarily as a great long term investment.

My learnings are as follows:

  • The period of low inflation we are now experiencing will not last forever, and instead will likely revert to the mean of 2.5% over the long run.
  • It’s in the best interest of the government to maintain some inflation but to limit it to a manageable rate so as not to have an adverse effect on the economy as a whole.
  • A portfolio invested primarily in stocks is the best option currently to maximize long term gains and outpace inflation. Long term gains from stocks should average 8-9% annually.
  • A portion of the portfolio allocated to REITs will provide some income while at the same time offering some protection against inflation by the nature of the trust’s holdings.

Readers: Do you consider the effects of inflation when making investment decisions? What investment vehicles do you use for protection? Finally, how much longer do you expect this period of low inflation to last? Let me know in the comments below!

6 thoughts on “Lessons from the Intelligent Investor Part 2: Inflation

  1. As always a tremendous write up Dustin! I have taken inflation into serious consideration within the last year. With the numerous quantative easing I believe we are going to see unprecedented rates of inflation. It is because of this that I am focusing heavily on blue chip dividend paying stocks. I like stocks that have large stable businesses that people cannot live without.

    For example there will come a time when people will have to decide between purchasing the newest iPhone or having enough food to eat. I have personally seen major inflation in relation to groceries. This however is not included in the government’s measure of inflation.

  2. Thanks again Marvin. Glad you enjoyed the article. Yes, our current low rates of inflation will not last forever, and they’ve been so low for so long that there’s a good chance it may go to the other extreme.

  3. I do not think about inflation when invest in stock and forex market. As inflation does not put much effect over it. Even think more about inflation when makes a plan to invest in Real Estate because it is directly affected by inflation.

  4. Inflation will always be there as a part of the economy. Positive inflation means growth of the economy and vice versa. It should be taken into consideration but to some extent. Investing in precious metals like gold and silver can act as a buffer against negative economic forces like inflation. This is because these are physical assets which can be converted into cash at any time. They have a value of their own all over the world and the value always appreciates with time.

    1. The problem I have with commodities is that the link to inflation is not that strong. Gold might be doing well, but over the last 30 years it is actually down from its high. Inflation has not be offset by bouts of significant deflation. From a wealth preservation perspective, there is no asset that is an inflation hedge. Your entire attempt at a portfolio is an inflation hedge. Since inflation does not incorporate things like oil and food (but does measure downstream effects of those increases) you probably need your portfolio to return a few percentage points above inflation per year to just break even. I’m talking about over the course of 5 or 10 years. That is actually a tall order when you consider conservative strategies would call a 5% return a year good. Adding in economic downturns that thrash you for 20-30%, 5% is not that impressive due to the ravages of time.

      I am currently writing a quasi-nonfiction story about the battle against the great enemy of time. In life and finance, time is the villain.

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