Are Stocks My Elusive Perfect Inflation Hedge? No
I’m still in search of the best way to combat the effect of inflation. My search has hit another dead end.
Over at Generation X Finance, Jeremy hosted a question-and-answer session with a couple of authors of a personal finance book. I asked a question and it was answered on this post. Here’s my question and the answer:
Q: In your opinion, what is the absolute best hedge against inflation?
A: Broadly speaking your investment options fall into three main categories: stocks, bonds, and real estate. Historically speaking, over the long-run, stocks have done the best job of fighting inflation amongst these three asset classes. When you think about this, it makes sense as stocks are pieces of ownership in underlying businesses – and businesses can raise their prices to keep up with inflation in order to maintain earnings growth. There certainly are more complex strategies to hedge against inflation (using options, derivatives, swaps, etc.). But if history is any guide, investing a portion of your long-term money in stocks is a keep-it-simple way to combat the corrosive effects of inflation.
I don’t mean to snipe at this answer, but it wasn’t exactly what I was looking for.
Here’s why. After adjusting for inflation, stocks basically don’t return squat. In return, you bear all their market risk. That’s not a solution.
For an explanation of what I mean, see the below graph (from Chartoftheday.com). When adjusted for inflation, the Dow Jones is now 3 times where it was in 1929. That’s a whole 1.6% return per year over the very long term. Now you get to pay taxes on that. And what about management fees (assuming you use the most common method of investing - mutual funds)? Even cheap funds like Fidelity and Vanguard charge at least a few tenths.
Sum it all up, and here’s what I get. Invest in stocks and keep your money there for a very long time. Try not to look when your investment whips up and down. Pay fees and the man. At the end of it all get exactly what you put in, in terms of real purchasing power. Great.
And what about extended periods of time like the seventies when investing in stocks got you killed in terms of real purchasing power. If this was 1982, I doubt very seriously the authors would be saying investing in stocks combats inflation. And, yes, I consider 1962 to 1982 a sufficient period of time to define it as ‘long-term.’ It’s long enough that someone could easily have spent their entire retirement in the time period.
…the search for the best inflation hedge continues…
inflation
June 26th, 2007 at 9:57 am
Thanks for the link back to that post.
In regards to the question, technically speaking the answer is correct. They say that out of the 3 main asset classes most people invest in (stocks, bonds, real estate) that stocks are likely to return the most over the long-term, which is true.
Unfortunately as you mentioned, even with the typical growth of the market when you begin to factor in inflation and taxes the real return may not be that good.
So the overall notion to put part of your long-term holdings in stock, as they suggest is probably the easiest way to achieve the highest amount of return without getting into more advanced hedging strategies.
They did allude to options and derivatives, which if you are truly looking for a solid hedge against inflation you could put together a strategy that could accomplish this.
What I do think you may be overlooking with inflation adjusted DJIA chart is that it is simply adjusting the raw number of the price of the dow and that’s it. When you factor in the action of compounding interest over the span of 20, 30 or 40 years in a real world portfolio the true value of your holdings would be significantly greater.
Many stocks offer dividends, if you own any bonds you receive interest and all of this money, if reinvested compounds in the account which boosts the real return over time more than just adjusting the value of an index for inflation.
I do still agree though that simply betting on stocks alone as an inflation hedge isn’t the optimal solution, it just happens to be the easiest for your everyday investor.