What is Inflation Risk and How to Invest?

May 29, 2021 — Leave a comment

Quiz!

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

  1. Growth stocks
  2. Real estate
  3. Certificates of Deposit (CDs)
  4. Bonds
  5. Cash
  6. Value stocks

What is Inflation Risk and How to Invest?

US inflation spiked to 4.2% in the past year (by April), more than double the Fed’s target and the average of the past 10 years. The Producer Price Index (PPI), that measures the cost of production, spiked even faster, by 6.2% over the past year. PPI movements tend to precede inflation (measuring consumer prices), meaning that even higher inflation is likely. There are a number of inflationary forces at play including government stimulus and low interest rates.

What is the risk of inflation? Inflation makes your money worth less, just like an investment decline. Unlike a decline in a diversified stock portfolio that tends to be a temporary event, inflation is a permanent decline. For example, in the 10 years 1973-1982 the purchasing power of Americans declined by 57% due to inflation. Unlike appreciating assets such as stocks, inflation does not enjoy sharp recoveries after steep declines. Add another decade to that period, and the inflation compounded to a 70% decline in the value of savings in those 20 years.

It is easy to forget the damage of inflation to your purchasing power after 10 years of below 2% annual inflation. Given that its damage is irreversible, it’s worth being well prepared. Some assets that may be at risk if inflation persists are:

  1. Bonds with a fixed rate. The prices of these bonds decline as interest rates go up, and the decline is greater the longer the term of the bond.
  2. Growth (high Price/Book) stocks that are valued based on earnings far into the future. This is especially true for the extremely expensive S&P 500 stocks that have valuations a mere 10% below the rare and extreme highs of 2000.

How can you invest with high inflation? To make up for losses to inflation you have to grow your money faster than the rate of inflation.

  1. Stocks (company ownership) tend to be defensive against inflation, since the inflation is made up of prices of products and services that companies sell.
  2. Real estate also tends to be defensive against inflation, since housing costs are part of the inflation calculation.
  3. Value stocks (low Price/Book) tend to do better than growth stocks (high Price/Book) in inflationary periods, because their value doesn’t depend so much on earnings far into the future.

Quiz Answer:

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

  1. Growth stocks [Correct Answer]
  2. Real estate
  3. Certificates of Deposit (CDs) [Correct Answer]
  4. Bonds [Correct Answer]
  5. Cash [Correct Answer]
  6. Value stocks

Explanations:

  1. Stocks sell products and services that are part of the inflation calculation, so they can do well on average. But, growth stocks (high Price/Book) are valued based on earnings far into the future. These earnings diminish in value faster with high inflation.
  2. Real estate tends to go up with inflation, since housing costs are part of the inflation calculation.
  3. Certificates of Deposit (CDs) have a fixed payment that becomes less valuable with inflation.
  4. Most bonds have a fixed payment that becomes less valuable with inflation. Floating rate bonds don’t have this issue, but they have very low returns.
  5. Cash declines in value directly with inflation.
  6. Value stocks (low Price/Book) are not dependent on earnings far into the future when the inflation has the opportunity to compound the most. Their products and services are part of the inflation calculation, and become more valuable.
Disclosures Including Backtested Performance Data

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Gil Hanoch

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