Intelligent
Investor
Chapter
2:
The
Investor
and
Inflation
• Fixed
dollar
investments
such
as
bonds
will
suffer
when
the
cost
of
living
increases,
as
will
the
value
of
the
dollar
• Stocks
offer
the
possibility
of
offsetting
the
decline
in
the
dollar’s
purchasing
power
with
dividend
and
price
appreciation
• Conventional
wisdom
is
that
during
periods
of
inflation
common
stocks
are
more
desirable
than
bonds
• The
intelligent
investor
recognizes
that
operating
on
this
assumption
without
regard
to
underlying
fundamentals
is
inherently
dangerous
• In
order
to
make
a
reasonable
estimate
of
how
to
handle
future
inflationary
situations
it
is
important
to
study
past
periods
of
inflation
• From
1915-‐1970
inflation
ran
at
roughly
2.5%
annually
(it
has
been
lower
since)
• Graham
suggests
3%
as
a
reasonable
estimate
of
inflation
going
forward,
but
admits
this
is
far
from
certain
• Rising
inflation
eats
into
the
returns
of
fixed
income
investments
• Example:
If
a
municipal
bond
has
a
coupon
rate
of
6%
and
inflation
is
running
at
3%
the
real
return
on
the
bond
is
only
3%
• When
deciding
which
asset
class,
stocks
or
bonds,
is
more
desirable
in
an
inflationary
period
the
investor
must
believe
their
total
return
on
common
stocks
will
be
greater
than
the
real
return
of
a
high
quality
bond
• From
1915-‐1970
common
stocks
appreciated
at
4%
annually
with
an
average
dividend
yield
of
4%
for
a
total
return
of
8%
annually
• These
returns
are
far
from
certain
going
forward
and
could
vary
significantly
depending
on
the
valuation
levels
at
which
they
are
purchased
• Correlation
between
stock
prices
and
increasing
inflation
are
mixed
at
best
• Increases
in
corporate
earnings
have
been
primarily
due
to
the
large
growth
of
invested
capital
from
reinvested
profits
• The
only
way
that
inflation
contributes
to
increased
common
equity
values
is
by
raising
the
rate
of
earnings
on
capital
investment
• Two
negative
impacts
of
inflation
on
corporate
earnings
are
increased
wage
rates
exceeding
gains
in
productivity
and
the
need
for
larger
amounts
of
funds
required
for
capital
investments
• Another
negative
effect
of
inflation
is
increased
interest
rates
for
companies
that
are
taking
on
new
debt
which
eats
into
profits
available
for
equity
owners
• In
conclusion,
stock
prices
are
likely
to
fluctuate
regardless
of
inflation
• Using
inflation
as
justification
to
buy
stocks
regardless
of
valuation
is
a
serious
mistake
• Graham
is
also
suspect
of
using
gold
as
a
store
of
value
during
inflation
• Real
estate,
another
hedge
against
inflation,
is
also
subject
to
fluctuations
in
value
• Large
scale
inflation
is
always
a
possibility
and
the
best
way
for
the
investor
to
carry
insurance
against
it
is
to
split
their
portfolio
between
common
stocks
and
high
quality
bonds
• Commentary
on
Chapter
2
• “Americans
are
getting
stronger.
Twenty
years
ago,
it
took
two
people
to
carry
ten
dollars’
worth
of
groceries.
Today,
a
five-‐year-‐old
can
do
it.”
–
Henny
Youngman
• Inflation
is
often
overlooked
because
of
what
is
known
as
the
“money
illusion”
§ If
you
receive
a
2%
pay
raise
in
a
year
when
inflation
is
running
at
4%
you
feel
better
than
if
you
had
a
2%
pay
cut
even
though
both
scenarios
leave
you
with
the
same
amount
of
purchasing
power
• Inflation
acts
as
a
stealth
destroyer
of
wealth
• Here
are
three
examples
of
inflation
wreaking
havoc:
§ From
1973-‐1982
the
consumer
price
index
rose
at
a
rate
of
9%
annually
and
was
accompanied
by
a
stagnant
economy
in
what
was
know
as
“stagflation”
§ Since
1960
almost
70%
of
all
market
oriented
countries
have
suffered
at
least
one
year
with
an
inflation
rate
of
above
25%
which
on
average
destroyed
53%
of
an
investor’s
purchasing
power
§ Rising
inflation
gives
countries
with
debt,
like
the
U.S.,
the
ability
to
pay
off
their
loans
with
a
cheaper
dollar
• Therefore
eliminating
inflation
is
not
in
the
economic
self
interest
of
debtor
nations
§ Stocks
typically
have
not
responded
well
to
either
large
amounts
of
inflation
or
deflation
§ Mild
inflation
is
fine
because
companies
can
pass
increased
costs
on
raw
materials
to
their
customers
§ High
inflation
forces
customers
to
stop
consuming
because
they
have
less
purchasing
power
§ The
author
proposes
two
modern
day
financial
products
that
can
serve
as
a
hedge
against
inflation
• REITs,
or
Real
Estate
Investment
Trusts,
are
companies
that
own
and
collect
rent
from
commercial
real
estate
properties
• TIPs,
or
Treasury
Inflation-‐Protected
Securities,
are
U.S.
government
bonds
that
rise
with
inflation
o Because
they
are
backed
by
the
U.S.
Treasury
the
risk
of
default
is
seen
as
very
low