People are often either surprised to hear that stocks are probably the best inflation hedge they’ll ever find – or they really don’t understand why.
Those who intuitively believe it believe it’s simply because stock prices tend to rise over time; but, so do prices for other things, generally, including real estate. After all, as a long-term hedge, most real estate is a good inflation hedge, as well. It’s only real drawback, most believe, is the lack of liquidity it entails.
When my parents retired, the common practice was to simply “ladder” bond or CD maturities as many counted on rising interest rates to offset inflation. While inflation had averaged only 2% in te 1950s and 2.3% in the 1960s, all of a sudden climbed to 6.2% in 1973 and by 1974 had reaced 11%. Bonds, of course, paid higher rates to the holders, but after taxes, the income didn’t keep up with inflation.
From 1973 to 1982, inflation averaged 8.7%! A little math reveals that the purchasing power of bond income had declined 57% in just one decade; and, as many found out, they were living longer, too!
Enter the 1980s and a newfound interest in stocks, which continued into the 1990s and even into the 2000s. But why?
The reason lies in a simple, basic premise: stocks represent shares of ownership in businesses – businesses that sell goods and services in the marketplace. When you eat breakfast, everything you eat or drink was grown, packaged, distributed, and sold by a business. Everything we consume was sold by a business. The largest providers, distributors, and sellers are publicly held – the ownership shares are owned by people like you and me – and often in their 401(k) plans through their ownership of mutual fund shares, which are shares of ownership in investment companies which, in turn, buy shares in publicly held companies.
So, if prices go up, stocks go up. Is it that simple? Actually, there’s more to it.
Take an (admittedly oversimplified) example of a company that generates $1 million in sales and $800,000 in expenses. Let’s assume the remaining $200,000 is paid out in dividends.
If inflation causes prices to double, sales rise to $2 million and expenses rise to $1.6 million, now creating $400,000 in dividends. Dividends have doubled, despite the fact that all margins have remained the same. That’s how stocks become an inflation hedge, with liquidity.
This is exactly what happened throughout the 1980s. The decade began with the S&P paying out around $7 in dividends, when the index paid out a 5.3% yield as it stood at $133. By 1990 it was paying out around $12.50 when the index was up to $340, for a 3.7% yield. As the yield went down, stock prices went up; yet, the investor saw cash flows rise from $7 to $12.50! This actually did better than inflation, which averaged 4.7% – up 58%.
Of course, dividends are not guaranteed and stocks have both business and market risk – a good reason why people relied on “blue-chip” stocks and a sound asset allocation process.
It’s also important to understand investment returns, including their measures (there’s more than one) and why most individual investors typically don’t do as well as institutional investors. If you’d like to learn more about this topic, you might want to see our report, which you can access here.
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991. Jim is Founding Principal of The Independent Financial Group, a registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.