In part 3 of my Intelligent Investor Series—I talk about Benjamin Graham’s warnings on inflation, how it impacts your portfolio, and how you can hedge against it, writes Steve Pomeranz.
If you’re just tuning into my Intelligent Investor Series, you can catch up on past episodes on my website, StevePomeranz.com.
Here’s a tongue-in-cheek quote that sets the stage for our discussion on inflation. It’s by Henny Youngman, an American comedian famous for his simple one-liner jokes. It goes: “Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five-year-old can do it.”
Nicely said, Mr. Youngman!
How inflation impacts annual returns
With that, let’s start. Let’s say you got a pay raise of 3% in 2016. While we always want more, chances are you were happy enough that you got a raise.
Then, let’s say a year later, your company declared a 3% pay cut in 2017. Well, takes no guessing because I am sure everyone was mighty unhappy about that.
But, as Graham reminds us, it’s all relative. What really matters is how you do after accounting for inflation.
The money illusion
If inflation was 6% in 2016, your 3% pay raise left you with 3% less purchasing power on your paycheck. Still, you were probably happy that you got a raise and likely felt positive about it through the year.
Now let’s assume inflation was 0% in 2017. That 3% pay cut left you with the same 3% drop in purchasing power as in 2016. But you were probably unhappy about the pay cut, dissatisfied with your employer, and I’ll bet that your workplace productivity was lower in 2017 because of that pay cut.
While your inflation-adjusted purchasing power was the same in both years, you were happy when you got a raise and sad when you didn’t. And this is what financial psychiatrists call the money illusion—as long as there is more money in your hand, you feel better off, even though its purchasing power has declined.
Money illusion extends beyond cash in your wallet
Money illusion is not limited to salaries but extends to a lot of other financial things. For example, customers often feel good about putting their money into certificates of deposit (CDs) and savings accounts when they see high nominal interest rates displayed in bank advertisements. This can sometimes be a trap because it lures customers away from stocks into the perceived safety of CDs, even though their inflation-adjusted returns are really low or even negative.
For instance, investors happily plowed a lot of their savings into 11% CDs in the 1980s, even though inflation ran at 13% and resulted in a 2% annual loss!
The same investors were bitterly disappointed to be earning only about 2% on CDs in later years even though their inflation-adjusted returns were slightly above break-even.
Consider today’s scenario: the highest CDs pay about 2.2 to 2.5 percent, which leaves us with about 0.3 to 0.6 percent after subtracting inflation at about 1.9%. Yet, no one’s happy about putting their money into CDs because the sticker rate is low even though they’re beating inflation and are better off than when CDs offered 11% or more.
Intelligent investors understand the erosive power of inflation, so they measure investing success based on real, inflation-adjusted returns, and do not fall into the trap of “Money Illusion.”
As an aside, governments that issue paper currencies like the concept of inflation because it reduces the value of the debts they’ve issued, so it’s in their best interest to keep inflation alive.
Inflation sizably cuts into purchasing power over time
Inflation has a profound impact on your purchasing power and your real portfolio returns. Most Americans do not think about inflation on a day-to-day basis. That’s because at about 2% currently, it’s almost a non-issue in our daily lives and spending habits. But inflation’s constant presence, year after year, even at two to three percent, steadily erodes purchasing power over time.
For instance, the purchasing power of $100 dropped almost 90% over the past 50 years, which is roughly the time span from when you start your first job to when you retire.
So, the money you saved when you were young must beat inflation year after year just to retain its purchasing power. To put it differently, if you saved your money under the mattress throughout your working life, you will end up with a lot of money in nominal terms, but its purchasing power would be significantly lower because of inflation. So, inflation is something we should definitely factor into our investing math.
Here’s a quick, true story. A client of mine for many, many years just recently passed away at age 101. The one thing that was notable about his investing habits over all the years we worked together was that he absolutely refused to invest in any stocks over his lifetime.
Now, fortunately for him, his money lasted throughout his lifetime, though I can’t tell what if any sacrifices he had to make along the way to achieve that. However, now his son and daughter, who, by the way, are in their 70s, have been taking care of him for a long time are looking at an inheritance significantly less that it had to be. All of that lost opportunity over those many years.
History warns of high inflationary periods
Getting back to the problems of inflation. Graham also addresses inflation from a historical perspective. Many of us have been lulled into inflation rates of one to two percent over the past ten years, but I don’t want you to fall into the trap of assuming that this is where it will stay for the rest of your working lives.
To put today’s low rate of inflation into perspective, consider this. Our economy faced one of its worst recent phases of inflation from 1973 to 1982, during which time the Consumer Price Index (CPI) rose at an annualized rate of nearly 9%!
In 1979, inflation spiked to 13.3%, paralyzing our economy. Prices of goods and services rose from a normalized value of 100 in 1973 to $230 by the end of 1982, shrinking the real value of one dollar to less than 45 cents!
It’s happened before, and it likely will happen again.
Hedging against inflation
Consequently, intelligent investors know that inflation is here to stay and find ways to protect against it. They do this by estimating the return they’d get on an investment after subtracting inflation and only purchase investments that have the potential of delivering adequate real returns.
Graham’s analysis of stock returns showed that stocks do not always beat inflation. For instance, periods of low or negative inflation have historically delivered poor stock market returns, as have periods of inflation in excess of about 6%.
But at other times, stocks do outperform inflation. For instance, between 1926 and 2002, stocks delivered positive real returns about 80% of the time. Though stocks do not always beat inflation, I, for one, like the stock market’s 80% odds of beating inflation.
Graham liked REITs and TIPS to hedge against inflation
Other investments, like real estate and bonds which adjust their interest based on the rate of inflation, are also investments that Graham liked.
That was the gist of Graham’s views on inflation, supplemented by a few of my own thoughts. And I’ll see you next time on the Intelligent Investor Series with more pearls of wisdom from Benjamin Graham.
You can find this and more at StevePomeranz.com
