Don't use stocks as an inflation hedge

There are far better ways to protect yourself, and although not all of them are good bargains, it pays to branch into different asset classes.

By MoneyShow.com Mar 9, 2012 5:52PM

Image: Woman reading newspaper in livingroom © Tetra images/Getty ImagesBy Howard Gold, MoneyShow.com


You've heard it so often you can probably repeat it in your sleep: Equities are the best protection against inflation.


Financial planners say it. Money managers say it. Pundits and gurus say it. Without a nice chunk of equities in our portfolio, we are told, inflation will ravage our net worth, and we may not have anything left for our very old age.


That's why some experts have even recommended that retirees or near-retirees hold 60% or more of their assets in stocks -- terrible advice, and it destroyed many people's finances and peace of mind during the crash a couple of years ago.


The market has come back since then -- without the participation of those who sold at the bottom in despair -- so maybe some advisors believe it was sound thinking after all.


But academic research, old and new, completely flies in the face of this conventional "wisdom." It establishes clearly that stocks are not a very good hedge at all against inflation, particularly high inflation. Even "Stocks for the Long Run" author Jeremy Siegel acknowledges that.


"Historically, that's been the case," said John Tatom, a finance professor at Indiana State University. "I claim that's one of the most well-established tenets in financial economics."


Tatom wrote in a 2011 paper that there is a strong negative correlation between inflation and real and nominal stock prices. "Contrary to opinion, equities are not a good hedge against inflation," he adds.


New research by three noted experts on asset prices confirms this. Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School have one of the world's deepest databases on the performance of stocks, bonds, bills and currencies, as well as inflation. It covers 19 different markets and goes all the way back to 1900.


In an article in the 2012 Credit Suisse Global Investment Returns yearbook, analysts found that during periods of marked inflation, equities easily outperform bonds, which are probably the worst investment to own during inflationary episodes. Yet equities gave a real return of -12% during those periods, while bonds lost 23.2%. Double ouch.


When inflation has been moderate and stable, equities have performed relatively well, the three professors concluded. "When there has been a leap in inflation, equities have performed less well in real terms. These sharp jumps in inflation are dangerous for investors."


Their conclusion? "High inflation reduces equity values."

So why have so many experts embraced equities as an inflation hedge? Because they're confusing the large total returns investors may have earned from equities over long periods of time with an actual "hedge" against inflation.


Because of their greater risk, equities tend to produce bigger rewards over the long run -- say, 20 years or more. 


But that's not quite in the bag, either.


Exhibit A: the lost decade. The average annual total return for the Standard & Poor's 500 Index ($INX) from 1999 to 2011 was -0.4%. So, we're going to need a hell of a good next eight years to reach the S&P's long-term averages of just under 10% a year in this 20-year period. Dow 36,000 anyone?


Of course, if you invested in certain types of stocks -- small-cap value, real estate investment trusts, and emerging markets -- you would have done well. But who knew that in 1999?


And when it comes to inflation, even the esteemed Siegel of The Wharton School of the University of Pennsylvania hedges his bets, so to speak.


"Over 30-year periods, the return on stocks after inflation is virtually unaffected by the inflation rate," he wrote in Kiplinger's last year. "Although stocks do well when annual inflation is in the range of 2% to 5%, their performance begins to falter when inflation exceeds 5%."


Why? Because "companies can't always pass along increased costs, especially in the case of an important raw material, such as oil," he wrote. "As a result, many companies will see their profits squeezed."


Siegel's conclusion: "Stocks are not good short-term hedges against rapidly increasing inflation, but bonds are worse."


So, what does that mean? If you own a lot of stock because you want to protect your portfolio against inflation, you probably should sell some.


For instance, if you're five to 10 years from retirement and you have 50% to 60% of your assets in stocks, you should reduce those holdings to 40 to 50% of your portfolio.


And if you're worried about inflation, you should take some of that money -- and sell some of your bond holdings, too -- to buy some asset classes that have better track records as inflation hedges. (Read Howard's take on why cash isn't trash.)


Such as? "In periods of high and increasing inflation, gold and commodities are definitely something you want in your portfolio," said Mark Johannessen, managing director of Harris SBSB in McLean, Va., and former president of the Financial Planning Association.


Dimson, Marsh, and Staunton's research backs him up. "Gold has on average been resistant to the impact of inflation," they write, but investments in gold often see volatile price fluctuations. In fact, they add, there have been long periods when the gold investor was underwater in real terms.


Not for the last decade, of course, when gold rose more than sevenfold before stalling below $1,900 per ounce. But the researchers are talking about the very long run.


Another good hedge: housing. Don’t everyone all groan at once. According to Dimson, Marsh, and Staunton, real house-price changes seem relatively insensitive to inflation. "Housing has provided a long-term capital appreciation that is similar in magnitude to gold," they add.


Unfortunately, U.S. housing has produced the weakest returns of major markets over the last century, so if you'd like to hedge against inflation with your home, pack up and move to Australia. Real estate investment trusts (REITs) may be a decent substitute, but there aren't as much data on their performance over many, many years -- and they've had a big run.

Finally, there are TIPs (Treasury inflation-protected securities), the inflation-linked bonds issued by the U.S. and other governments. Smart people like David Swensen, Yale’s chief investment officer, recommend them for individual investors as good protection against inflation. But they're very expensive now.


So, what should you do? I'd take some profits in your stock and bond holdings and buy small positions (maybe 5% of your portfolio each) in gold, commodities, REITs, and TIPs ETFs, preferably when they’ve sold off a bit, too.


Then, I'd keep 40% to 50% in stocks, 20% to 30% in bonds, and another 10% in cash. That way, you’ll have some protection against inflation, deflation, and just normal life.


And if your financial advisor tells you to buy more stock to keep from outliving your money, tell him or her that in the long run, we're all dead.


Howard R. Gold is editor at large for MoneyShow.com and columnist for MarketWatch. You can follow him on Twitter @howardrgold and read why Republicans need to stop pining for a white knight at The Independent Agenda.
4Comments
Mar 12, 2012 6:52AM
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Stocks have always been an excellent Hedge against inflation.  It is true that infaltion is not a friend of stocks, but stocks have been a PROVEN hedge against inflation.  They have out performed inflation and that bit above the rate of inflation is their real return on investment.  

 

Besides where else can you invest cash to avoid inflation?   I can think of a only a few places, Specie, Foreign currencies and stocks.   Real Estate, now in a corrective phase, was far over valued.  This over valuation caused by government policies. 

 

I will stick with my inflation hedges.  The Fed plans continued massive devaluation of the dollar...

Sell your Treasuries BEFORE it's haircut time in the USA...

Mar 10, 2012 4:35PM
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Wait a minute! You berate financial planners and investment advisors ("terrible advice") for recommending their clients hold 60% in stocks in their retirement portfolios, and then you conclude with a recommendation to hold 40% to 50%! Then you recommend 5% in gold and 5% in commodities? Have you looked at he standard deviation on those assets, even if they do "hedge" inflation to some degree? Talk about the possibility of ruining your "peace of mind", or your ability to sleep better at night.

We all have something called "recency bias" which causes us to take action based on what has recently happened to us, discounting the probability of future events (i.e. the focus on the "lost decade" of S&P 500 index returns). I advice clients, on a fee-only basis, for a living. I live and work in the real world, not an ideal one where results are crunched out on a spread sheet in hindsight and the thing that you "should have done" can be seen quite clearly. We constantly battle our client's two biggest motivating emotions that lead to "bad" financial planning behavior - fear and greed (driven primarily, in my opinion, by video and print media's constant barrage of "what should I buy now" stories).

My advice - start with your goal or objective ("what am I trying to achieve?"); determine how much volatility you are willing to bear; based on these two inputs come up with a long-term investment allocation and measure the projected return and volatility (projected standard deviation) to make sure you can "live" with both of them - if not, make adjustments; align your investment portfolio with your new allocation evenly over some period of time (weekly, monthly, quarterly); rebalance your portfolio quarterly...no matter what...back to the allocation strategy; potentially adjust the allocation/volatility as you approach the goal or you understand your tolerance for volatility better; ignore the short-term (and the media, who don't know you and have no stake in the consequences to your actions) and stay focused on the long-term.

Timothy A. Knotts, CFP®

Certified Financial Planner™

Mar 12, 2012 3:22AM
avatar
The real world is ultimately based on movements of tangible assets.  Any paper based asset is a claim to it in equity (stocks) or indenture (bonds).  As for cash, a claim to nothing (you accept it on faith that others will too).  All of this requires the ongoing integrity of the law to maintain.

So --- given the complete and growing corruption in government and finance, I now ask you, " HOW DO YOU SLEEP AT NIGHT ON PAPER INVESTMENTS ?"

Take the red pill folks.

Mar 11, 2012 11:08PM
avatar
Lots of bull and hogwash. Stocks are a good investment after deflation and before high inflation. Which is where we are now. To say stocks are not a good hedge against inflation is bull. You wouldn't want to be putting new money into stocks once high inflation is here, it's not yet, but would be selling stocks to buy CDs once the Fed starts raising rates to dampen inflation. That migh happen in 2013 or 2014 but not now because Iran crisis is inflating oil prices and stuff dependent on oil.
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