The Investor And Inflation
Inflation and the fight against it is something that has been going on forever it seems and the fear that it can shrink the purchasing power of a currency has greatly influenced an investor's behaviour.
For example, between 1965 and 1970, the average annual inflation rise was 4.5% and because common stocks have proven to generate more returns than bonds, they are better investments for protection of inflation.
This is not true all the time, because common stocks bring uncertainty with them and their past performance does not guarantee a good future performance.
Many investors overlook the inflation factor when considering investments. The simple reason is that between 1997 and 2002, inflation in The United States averaged 2.2% and in recent years it has hovered around 1-2% which is not a huge number.
Another reason is the “money illusion”. For example, if we get a pay rise of 5% while inflation rises 7%, we feel better, compared to if we took a pay rise of 2% and the inflation is 1%. The first situation leaves us in a -2% cut-off from our original wages, i.e., our wages have increased in monetary terms, but our purchasing power has decreased because a good’s price has increased more than the increase in our wages, but as long as the nominal change is positive, an investor feels better.
The below figure illustrates the two situations:
To fight inflation, Graham suggested two inflation fighters to investors:
1) REITs or Real Estate Investment Trusts- These are companies that invest and collect rent from commercial and real estate properties. This can be a low cost-effective method of combating inflation in the long-run, while this method is not likely to be a full-proof inflation-fighter.
2) TIPS or Treasury Inflation-Protected Securities- TIPS are U.S government bonds. They go up in value as soon as inflation rises. They provide 100% protection against inflation and are also backed by the full faith and credit of the government of the United States. So, in one easy purchase, we can ensure protection from inflation. TIPS can be volatile in the short run and are best suited for long-term investors.
The point here the author tries to explain is that our Investment returns should be at least equal to the expected inflation rate otherwise we can lose the purchasing power of a good consumed by us. This can be better understood from the following example:
If today the price of a bag is $100, we have the capacity to earn one bag from $100. One year later, if the price of the bag rises to $107 and we generate a 3% return from $100, we have the capacity to purchase 0.96 units of a bag, which is less than what we were able to purchase a year ago.