Last Updated on April 26, 2022 by Rational thinking
Since the early 1980s inflation has been falling, at least according to official numbers. As a result, the interest rates have dropped significantly, even to nominal negative rates in some countries. Because of this, a whole generation of investors have never invested in an environment with rising inflation and don’t know how to protect their capital.
In this article, we look at what inflation is, explain Warren Buffet’s Misery Index, describe which asset classes have performed best over the last 28 years, and show how you can protect your assets, wealth, and savings from inflation. Over the long term, the best way to protect your assets and capital is by investing in productive assets that have high returns on their capital. Most likely, the stock market is the best protection you have against inflation (as long as it’s not hyperinflation).
What your assets are worth decades ahead is dependent on inflation. Thus, you should always evaluate your returns in real rates and not in nominal rates.
What happens if the inflation rate rises to, for example, 7%? What happens to your savings and assets? Will you be able to maintain the purchasing power? Is your capital protected from a high inflation rate?
Depending on your timeframe, what is the best hedge against inflation? How do you protect the purchasing power of your assets?
What is inflation?
Inflation is mostly defined as a rise in consumer prices – the Consumer Price Index (CPI), normally published monthly in most countries. When prices rise you get less bang for your bucks, and your cash ends up short compared to before.
The opposite of inflation is deflation, ie. a decrease in the price level.
Why are prices going up and down (mostly up)? That is a very complicated question to answer, but over time the correlation between prices and the money supply is high.
The more money in circulation, the more money chasing the goods. However, some products have fallen even in nominal prices, like computers. The reason is increased productivity.
Over the last decade since the GFC in 2008/09, the money supply has increased substantially in most Western countries, but the velocity of the money has been subdued and thus not (so far) lead to run-away inflation.
The money supply is a complicated issue in itself. However, over the long run, there is strong reason to believe that increased money supply growing faster than economic output leads to inflation.
Economics is not a study with exact answers like in math or chemistry. Economics involves money, and money is the study of how people behave with money (according to Morgan Housel). Thus, it’s sometimes very hard to predict how the future looks like economically.
What is hyperinflation?
The Germans fear inflation and increased money supply. The reason is simple: they still remember what happened during the Weimar Republic in the 1920s when Hausfrauen was lining up early in the morning to buy vegetables in wheelbarrows before prices were hiked in the evening.
Hyperinflation is when inflation is “out of control” and people panic. In recent years, we have seen rampant inflation in Russia, Venezuela, Argentina, and Turkey. Hyperinflation leads to capital flight, black markets, bartering, and little long-term planning, which is all very bad for society.
Needless to say, high and unpredictable inflation is very bad for the economy and leads to a reduced standard of living for the majority of people.
What is the CPI (Consumer Price Index)?
CPI is the abbreviation for Consumer Price Index and is used to measure the rate of inflation. The idea is that such an index mirrors a wide basket of everyday goods and services consumed by an average household. We can say the index measures the erosion of living standards measured against the rise in wages and incomes.
Obviously, the CPI is just a generalization and average that has a lot of drawbacks. There can never be an agreement on a basket of goods and services that mimicks everyone’s preferences: It’s no problem making the CPI higher or lower by cherry-picking the included items.
What products are included in the CPI?
The CPI measures the prices of the following:
- Food and beverages
- Housing (rent, furniture, etc.)
- Transportation (gasoline, tolls, etc.)
- Medical care
- Recreation (pets, tobacco, TV, sports etc.)
- Communication (computers etc.)
- Utilities (water, sewage etc.)
- Excise taxes
However, what is not included is just as important to know:
- Taxes and social taxes
- Investment vehicles (stocks, bonds, real estate)
Many pundits claim the CPI underrates real inflation. Perhaps they’re right. The CPI is just averages and averages don’t fit all households.
What is the best rate of inflation?
Most economists favor a low but steady rate of inflation: not too high and not too little, claiming deflation is even worse. Central banks always keep a watchful eye on the inflation rate and most Western central banks target 1.5 to 3% as “optimum”.
Which assets protect against inflation?
The most likely assets to invest in are stocks, bonds, real estate, and commodities. Cryptocurrencies are a new innovation, and their lack of history makes it hard to judge their future potential as a hedge against inflation. Bitcoin is presumed to be a good inflation hedge, but its history is still very short.
Thus far, it’s hard to argue bitcoin is a hedge against inflation. Bitcoin has risen in value because of a number of reasons, but inflation is probably one of the least important factors behind its move up.
We made our own chart in OpenOffice showing the performance of different asset classes (except bonds) from 1993 until July 2020:
SPY is the ticker code of the ETF that tracks the S&P 500 and is including reinvested dividends.
Clearly, the winner is the stock market, which makes sense (see more about that later).
However, these are averages and they involve wide generalizations. For example, real estate prices in downtown Seattle have certainly been different from the home prices in Rapid City, South Dakota.
The same goes for stocks: unless you hold a broad basket of stocks, your performance can vary a lot from the S&P 500. Most empirical evidence suggests retail traders fail to beat the “market” by a wide margin and we advise you to keep most of your stock investments in broad ETFs or mutual funds.
The CPI has risen very slowly over the period, and we suspect the CPI underreports the real inflation rate.
Is gold a hedge against inflation?
Gold … has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
Warren Buffett, the shareholder letter of 2011.
Gold has existed for thousands of years, and its supply is limited by what we can dig out from the ground. According to most studies we have seen, gold has managed to keep its purchasing power compared to the CPI a long way back.
But as an investor, you want to increase your purchasing power. In such a scenario, gold fails.
The problem with gold is its lack of productive value. Gold is just gold – it doesn’t create any goods and services.
From 1985 to July 2020, the S&P returned about 1 750% while gold returned just 600%. If you managed to reinvest the dividends, the S&P 500 grew at 11% annually – 4 000%. Compared to stocks, gold is an inferior investment over time.
Let’s have a look by looking at gold vs. the ETF with ticker code SPY which tracks the S&P 500 – including dividend reinvested:
Gold kept pace with stocks until 2013 but has since then fallen way behind.
In our opinion this makes sense. Any productive asset will over time beat an unproductive asset. If you own a basket of stocks that have higher returns on capital than inflation you are unlikely to be a victim of the Misery Index:
Warren Buffet’s Misery Index:
Back in the 1970s, when inflation was rampant, Warren Buffett made his own Misery Index. The Misery Index was simple:
The Misery Index is simply taking the return on invested capital (ROIC) or return on equity (ROE) and deduct the inflation rate and taxes paid.
In many cases this number was negative!
This brings us to what we believe is the best hedge against inflation:
Stocks are most likely the best hedge against inflation
After all, what you want to take home is fully dependant on the real returns, not the nominal returns. In the long run, shareholders get what is left after inflation and taxes, just like Warren Buffett’s Misery Index explains.
If your portfolio has a high return on invested capital (ROIC) or a high return on equity (ROE), you have a wide margin of safety.
For example, if your portfolio consists of stocks that on average have a 20% return on capital, your business is operating at a huge margin of safety, ie. operating margins. Moreover, most likely this indicates your portfolio of stocks has pricing power and can transform higher prices over to the end-users.
Think about it. Business as a whole can’t survive unless the costs are passed on to the consumers (in the long run).
Is real estate a hedge against inflation?
Real assets supposedly fare well over time and real estate is an asset class many already own via homeownership.
But how good a hedge against inflation has real estate been historically? It’s hard to answer because real estate is a lot more fragmented asset than stocks. Not only is each property unique in itself, but we have many categories of real estate: residential, office, retail, factories, etc.
Because of this, it’s hard to construct any index. The good thing is that you can get access to REITs listed on the stock exchange and get a broad diversification easily.
The chart above shows home prices have lagged stocks. However, this doesn’t include any rental yield, and neither does it include leverage. We don’t recommend leverage, but obviously if you have a rental property with moderate leverage you will do well over time adjusted for inflation (and have rental income along the way).
Why will real estate provide a hedge against inflation?
Typically, real estate consists of land, materials, and labor, all factors consumed in the construction of a building on a piece of land. The amount of land is given and exits in limited supply. Over time, both labor and materials have a high correlation with the CPI as its one of the main components.
The downside of real estate is that it’s a decaying asset the depreciates in value unless it’s properly maintained. If you do nothing, you own a pile of rotten rubbish after 100 years.
What is the cost of maintaining a property? Probably around 1% of it’s value is needed every year to maintain the value. If you are a landlord, most of the costs can be passed on to the tenants.
All in all, we believe real estate has been a good hedge against inflation over time, as long as you keep a diversified portfolio like for example, this study suggests.
Who benefits from inflation?
Those who have loans benefit greatly from inflation. Every dollar borrowed diminishes in value by the inflation rate every year. In addition, very rich people are much better at adjusting to inflation by for example borrowing against their assets.
Who is most hurt by inflation?
The value of money drops by the inflation rate, and thus, those who keep cash see their value drop like clockwork every year. Likewise, lenders get repaid by money that is of less value compared to when it was lent.
We suspect those at the low end of the income table suffer the most. Inflation is a “silent and hidden” tax. Because of excessive borrowing, we believe indebted Western governments will inflate their way out of debt. Most likely future pensions deteriorate compared to purchasing power. Better prepare and save and invest ahead.
Why is inflation bad?
Inflation has two major drawbacks:
Difficult to plan
If the inflation expectations are low it’s easier to plan ahead. If the expectations move, it gets tricky to estimate the costs and profits of projects that take years to develop.
Inflation raise inequality
The gap between rich and poor grows when inflation goes up. Why is that?
Social services and pensions frequently lag the CPI. Furthermore, well-off wage earners in general offset increased living costs with rising incomes. The research we have seen indicates the GINI coefficient increases in countries with rampant inflation that leads to inflation inequality.
Inflation is mostly measured by looking at the CPI. To maintain your purchasing power and protect your assets and capital, we believe that stocks offer the best inflation hedge (long term).
By looking at the last 28 years, we find that stocks offer better protection than gold, commodities, and homeownership. We believe this makes sense. If you own a basket of companies that produce goods and services, you own a part of all value creation in society.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.