A fellow blogger over at Free Money Finance recently posted a concern of his, and mine. Inflation could be just around the corner, and I don’t want all of my money wiped out because I lose my buying power. Think about your nest egg, if inflation shoots up and stock market performance doesn’t keep up then you are going to lose money in the long run. Many people cite precious metals as a great hedge for inflation. I just don’t buy it. For one thing it’s easy to show that precious metals are a great hedge, or a bad one, depending on when you actually invest in them. For the other, I just don’t think precious metals are very precious anymore. They aren’t a primary currency, and have little industrial application. Like a dollar, people just “believe” in gold. If they they can lose faith in the dollar, they can lose faith in gold.

But that only explains that precious metals like gold may not be a good investment to protect yourself against inflation. That doesn’t explain why I’m not worried about inflation.To figure out why I’m not worried, we have to look at why people are worried. Traditionally, we all put our investments in stocks and bonds. We don’t want bonds during inflation because the fixed interest rate would kill us. A 5% bond looks great if inflation is 0% but if inflation is 10% you’re getting killed. Likewise, people worry about the macroeconomic effects on the stock market were inflation to become a problem. Inflation raises prices on everything, and so we can afford less. We buy less and company’s don’t make enough money. The stock market suffers.

So we look for alternative investments that will protect us in the case of inflation. They have Treasury Inflation Protected Securities, otherwise known as TIPS, which are government bonds with an interest rate that changes with inflation. But this will only give you a marginal premium over inflation, and most people don’t want to hold them during period of low inflation, so they can take advantage of better returns. What we are looking for then is an asset class that we can hold all of the time, that offers decent returns and some kind of protection from inflation. You’ve got real estate, commodities, private business, cash in a Folgers can, and some other options. But these options are usually difficult for the layman to get into, or they don’t understand them, or they don’t offer the kind of liquidity they need. What is a guy to do to get some inflation protection around here?

Remember before when I said during periods of inflation businesses suffer and so the stock market does too? That’s not actually true. Inflation exists because more money is available to purchase the same amount of goods. Supply and demand, we have a large supply of money and demand the same goods. The result is price inflation. Inflation requires high levels of demand. If we are not making purchases the prices will fall. So in the case of price inflation business sales and revenues should look fairly good. In theory, the businesses themselves will have to pay higher prices for the goods they purchase, but that isn’t always the case. Even if it were, for us to experience inflation the businesses would have to be passing on those expenses to us. The net effect is that inflation doesn’t really matter to businesses. Yes there are exceptions, but the NET effect in business is a wash.

What’s the point to all this? My point is I’m not concerned about inflation so long as my nest egg is invested in stocks I’m not one bit worried about inflation. To back up my claim I’ve done a little research. This marks maybe the second or third time ever that I’ve put more than 20 minutes into a post. It’s usually easier to speculate and let someone else do the research but I wanted to know for myself this time.

Below is a table I made. It contains the 20 highest inflation rates in the United States since the end of WWII and the return for the S&P 500 in that year.

Year Inflation Rate S&P 500
1990 5.39% -3.42%
1989 4.83% 32.00%
1984 4.30% 5.96%
1982 6.16% 21.22%
1981 10.35% -5.33%
1980 13.58% 32.76%
1979 11.22% 18.69%
1978 7.62% 6.41%
1977 6.50% -7.78%
1976 5.75% 24.20%
1975 9.20% 38.46%
1974 11.03% -26.95%
1973 6.16% -15.03%
1971 4.30% 14.54%
1970 5.84% 3.60%
1969 5.46% -8.63%
1951 7.88% 23.10%
1948 7.74% 9.51%
1947 14.65% 2.56%
1946 8.43% -12.05%
Summary Statistics
Maximum 14.65% 38.46%
Minimum 4.30% -26.95%
Median 7.06% 6.19%
Average 7.82% 7.69%
St Deviation 0.03 0.18
Beta 0.11

At first glance it doesn’t look like much.  It’s a bunch of numbers that don’t seem to really act the same.  Sometimes inflation is really high and the S&P does well.  Sometimes the S&P does terribly.  However if you take the average inflation rate and compare it to the average S&P return, the averages are very similar.  The S&P return is only slightly less, and I’m sure a statistics nerd with a z-table could back me up on this, this difference is statistically insignificant.

What the average is showing us is that when we experience periods of high inflation, the stock market keeps up (on average).  You aren’t going to experience great gains, but you technically won’t lose any buying power either.

Furthermore, there is a statistical measurement known as Beta in finance.  Beta usually cited in terms of a stock’s beta to a market return.  For example, when a stock has a beta of 1, everytime the stock market goes up 5%, the stock goes up 5% too.  When it goes down 5%, so does the stock.  In otherwords, they are perfectly correlated.  The closer the beta is to 0, the less correlation there is.  The beta of the S&P 500 with respect to inflation is 0.11, which is practically nothing.  If you’re looking for an asset to protect you from inflation, you want something that isn’t correlated with inflation.

The story the summary statistics are telling us is that during periods of high inflation, the stock market keeps up on average.  And, during periods if high inflation, the stock market return isn’t related to the high inflation.  It’s almost two stories, but it’s also an example a relationship without correlation.

I’ve rambled long enough, my entire point is you don’t need to look for an asset to protect you from inflation if you’re already invested in stocks.  Stocks do a decent job on their own protecting you from inflation because their returns have nothing to do with inflation.

Disclaimer: This post is not meant to be a definitive answer on the inflation protection argument.  I’m merely looking at some numbers and contributing to the conversation.  This is also only looking at periods of high inflation, and not comparing inflation every year to stock market returns.  Were I a PhD in finance I’d devote a couple of months to studying this data, but I’m not, so I didn’t.
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categories: economics, investing, personal finance