What, then, can the intelligent investor do to guard against inflation?
The standard answer is “buy stocks”—but, as common answers so often are, it is not entirely true.
Figure 2-1 shows, for each year from 1926 through 2002, the relationship between inflation and stock prices.
As you can see, in years when the prices of consumer goods and services fell, as on the left side of the graph, stock returns were terrible—with the market losing up to 43% of its value. When inflation shot above 6%, as in the years on the right end of the graph, stocks also stank. The stock market lost money in eight of the 14 years in which inflation exceeded 6%; the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.
The historical evidence is clear: Since the advent of accurate stock-market data in 1926, there have been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through 1998–2002). In 50 of those 64 five-year periods (or 78% of the time), stocks outpaced inflation. That’s impressive, but imperfect; it means that stocks failed to keep up with inflation about one-fifth of the time.
TWO ACRONYMS TO THE RESCUE
Fortunately, you can bolster your defenses against inflation by branching out beyond stocks. Since Graham last wrote, two inflation-fighters have become widely available to investors:
REITs. Real Estate Investment Trusts, or REITs (pronounced “reets”), are companies that own and collect rent from commercial and residential properties.10 Bundled into real-estate mutual funds, REITs do a decent job of combating inflation. The best choice is Vanguard REIT Index Fund; other relatively low-cost choices include Cohen & Steers Realty Shares, Columbia Real Estate Equity Fund, and Fidelity Real Estate Investment Fund. While a REIT fund is unlikely to be a foolproof inflation-fighter, in the long run it should give
you some defense against the erosion of purchasing power without
hampering your overall returns.
TIPS. Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds, first issued in 1997, that automatically go up in value when inflation rises. Because the full faith and credit of the United States stands behind them, all Treasury bonds are safe from the risk of default (or nonpayment of interest). But TIPS also guarantee that the value of your investment won’t be eroded by inflation. In one easy package, you insure yourself against financial loss and the
loss of purchasing power.
There is one catch, however. When the value of your TIPS bond rises as inflation heats up, the Internal Revenue Service regards that increase in value as taxable income—even though it is purely a paper gain (unless you sold the bond at its newly higher price). Why does this make sense to the IRS? The intelligent investor will remember the wise words of financial analyst Mark Schweber: “The one question never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax complication, TIPS are best suited for a tax-deferred retirement
account like an IRA, Keogh, or 401(k), where they will not jack up your taxable income.
Do not trade them: TIPS can be volatile in the short run, so they work best as a permanent, lifelong holding. For most investors, allocating at least 10% of your retirement assets to TIPS is an intelligent way to keep a portion of your money absolutely safe—and entirely beyond the reach of the long, invisible claws of inflation.
The standard answer is “buy stocks”—but, as common answers so often are, it is not entirely true.
Figure 2-1 shows, for each year from 1926 through 2002, the relationship between inflation and stock prices.
As you can see, in years when the prices of consumer goods and services fell, as on the left side of the graph, stock returns were terrible—with the market losing up to 43% of its value. When inflation shot above 6%, as in the years on the right end of the graph, stocks also stank. The stock market lost money in eight of the 14 years in which inflation exceeded 6%; the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.
The historical evidence is clear: Since the advent of accurate stock-market data in 1926, there have been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through 1998–2002). In 50 of those 64 five-year periods (or 78% of the time), stocks outpaced inflation. That’s impressive, but imperfect; it means that stocks failed to keep up with inflation about one-fifth of the time.
TWO ACRONYMS TO THE RESCUE
Fortunately, you can bolster your defenses against inflation by branching out beyond stocks. Since Graham last wrote, two inflation-fighters have become widely available to investors:
REITs. Real Estate Investment Trusts, or REITs (pronounced “reets”), are companies that own and collect rent from commercial and residential properties.10 Bundled into real-estate mutual funds, REITs do a decent job of combating inflation. The best choice is Vanguard REIT Index Fund; other relatively low-cost choices include Cohen & Steers Realty Shares, Columbia Real Estate Equity Fund, and Fidelity Real Estate Investment Fund. While a REIT fund is unlikely to be a foolproof inflation-fighter, in the long run it should give
you some defense against the erosion of purchasing power without
hampering your overall returns.
TIPS. Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds, first issued in 1997, that automatically go up in value when inflation rises. Because the full faith and credit of the United States stands behind them, all Treasury bonds are safe from the risk of default (or nonpayment of interest). But TIPS also guarantee that the value of your investment won’t be eroded by inflation. In one easy package, you insure yourself against financial loss and the
loss of purchasing power.
There is one catch, however. When the value of your TIPS bond rises as inflation heats up, the Internal Revenue Service regards that increase in value as taxable income—even though it is purely a paper gain (unless you sold the bond at its newly higher price). Why does this make sense to the IRS? The intelligent investor will remember the wise words of financial analyst Mark Schweber: “The one question never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax complication, TIPS are best suited for a tax-deferred retirement
account like an IRA, Keogh, or 401(k), where they will not jack up your taxable income.
Do not trade them: TIPS can be volatile in the short run, so they work best as a permanent, lifelong holding. For most investors, allocating at least 10% of your retirement assets to TIPS is an intelligent way to keep a portion of your money absolutely safe—and entirely beyond the reach of the long, invisible claws of inflation.
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