Inflation Q&A

4/5/2010


Q Inflation is low. Should I be worried that it will rise?
A Probably not in the near term. The Blue Chip Economic Indicators consensus projects the Consumer Price Index — the most common inflation gauge — will rise 2.2% this year and 1.9% next year. Inflation often rises when money is cheap, but it has remained low (2.2% year-over-year in February) despite historically low interest rates. Expectations for the next two years are well below the average of 2.8% since 1990 and the average of 3.8% since 1948.

The Blue Chip consensus calls for inflation to average 2.4% over the 10-year period from 2012 to 2021. Economic forecasts are just educated guesses, and we do not put too much stock in any long-range forecast. However, most economists expect inflation to remain below long-run averages over the next five to 10 years.

Q OK, I’m not worried about near-term inflation. So why should I think about inflation at all?
A Because over long periods of time, inflation drags on investment returns. From 1926 through 2009, large-company stocks delivered an annualized return of 9.8%, according to Morningstar. A $1 investment in large-company stocks in 1926 would have blossomed to more than $2,574 during that 84-year period. But adjusted for inflation, the investment is worth just $215.

TOTAL RETURNS, 1926-2009
Value of $1 Invested in:
Before
Inflation
($)
After
Inflation
($)
Large-company stocks
2,574
215
Small-company stocks
12,639
1,055
Long-term corp. bonds
123
10
Treasury bills
21
2
Source: Morningstar.

Q So what do I do to protect my portfolio against inflation?
A In the short term, you can try to offset inflation by investing in commodities or other assets considered inflation hedges. However, the effectiveness of such strategies is mixed. They do provide a hedge, but they don’t necessarily enable market-beating returns.

Commodities and real estate are considered hedges against inflation because they tend to increase in price during periods of rising inflation. Treasury Inflation Protected Securities (TIPS) represent another strategy. The principal value of these bonds increases with the Consumer Price Index.

In the short term, TIPS bonds, commodities, and real estate may offer some inflation protection, and holding 5% to 10% of portfolios in such instruments can make sense as a hedge. But over the long haul, real property, commodities, and TIPS are unlikely to match the returns of stocks.

Since 1950, the price of gold has risen at an annualized rate of 5.6%, while oil prices have increased at a 5.8% clip. Real estate delivered an annualized return of 8.3%, which reflects both capital appreciation and estimates for income return through January of this year. However, large-company stocks managed an 11.1% annualized return during that period. Those growth rates equate to returns of nearly 2,600% for gold, 2,900% for oil, and 12,000% for real estate, all well behind the 54,000% return of large-cap stocks.

Since its inception in 2001, the Vanguard Inflation-Protected Securities ($12; VIPSX) fund has delivered an annualized return of 6.6%. While the return looks nice relative to the S&P 500 Index’s roughly flat returns during that difficult period, investors should not expect TIPS to match stock returns over time.

For the long term, the best weapon stock investors can bring to bear against inflation is high returns. Nearly every investment denominated in dollars will feel the effects of inflation. While commodities and TIPS bonds offer diversification benefits in an equity-focused portfolio, at the end of the day, the best portfolio is the one that delivers the highest return at an acceptable level of risk.


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