[Note: This article was first posted on May 8 and had to be reposted due to website technical error.]

My last two posts (here and here) examined whether stocks are a good hedge against inflation.  This is my third and last post in this series, at least for now.  I reviewed many articles and research papers, and I found three common arguments against stocks as an inflation hedge:

1. Stocks and inflation have a “strong” negative correlation, meaning that stocks do poorly when inflation rises.
2. People confuse the long-term return from stocks with their ability to hedge inflation, which are two different things.
3. Academic research established long ago that stocks are a poor inflation hedge.

In my last post, I tackled the first argument.  After independently scrutinizing U.S. stock and inflation data, I found there’s a weak negative correlation between real (inflation adjusted) stock returns and concurrent inflation, and nominal stock returns are poorly correlated with inflation (nearly random).  I also pointed out why the most appropriate comparison to inflation uses nominal stock returns not real returns.

That brings us to the second argument for why stocks are a poor inflation hedge: people confuse long-term stock returns with hedging.  To avoid this problem, we need a clear definition of the term “hedge”.

What’s A Hedge Anyway?

We know that long-term stock returns have historically outperformed every other asset.  But good long-term performance is no guarantee that stocks will consistently counteract shorter-term inflation changes.  Unfortunately, media articles and even some academic studies use the term “hedge” broadly, which causes at least two points of confusion:

1. What’s the relevant time frame for a hedge?
2. What’s an effective hedge?

Here’s a basic initial definition of “hedge” from Investopedia:

• “A hedge is an investment to reduce the risk of adverse price movements in an asset…A perfect hedge is one that eliminates all risk in a position or portfolio.  In other words, the hedge is 100% inversely correlated to the vulnerable asset.  This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost.”

(The above definition focuses on “negative” or “inverse” correlations between investments.  However, the perfect hedge against inflation would have a 100% positive correlation with inflation, where returns increase as inflation increases.)

Hedging Time Frame – Regarding the first point of confusion, the Investopedia definition does not address the likely time frame for a hedge.  In my view, inflation hedging over the very long-term is illogical for most investors.  For example, the annualized inflation rate since 1992 has been a low 2.3%.  Hedges against inflation during this time would have generated consistently low relative returns, while the U.S. stock market performed well (the S&P 500 has an annualized return of 9.7% since 1992).  Although often overlooked, the concept of hedging is most relevant over much shorter time frames than the decades-long horizons of most long-term investors.

The Effectiveness of A Hedge – Regarding the second point of confusion, Investopedia provides an unrealistic “perfect” example of a hedge, but no real-world example.  Investopedia at least clarifies that we shouldn’t expect any real-world asset to act as a perfect hedge against anything.  I liken this observation to one of Rick Ferri’s key tenants about asset diversification: the idea of consistently negatively correlated assets is a fantasy.   Although for certain periods some assets may have a strong negative correlation, there are no sets of assets that increase in value and have consistent negative correlations with each other over long periods.  For example, despite the fame of bonds as one of the best hedges against stock movements, as this graph from Ferri shows, the correlation between stocks and bonds is imperfect and has changed substantially over time.

Similarly, no one should expect stocks or any other asset to provide a perfect positive correlation with inflation.  And to the extent that any correlation exists today, we should expect it to wax and wane, or possibly even reverse tomorrow.

An Adequate Real-World Hedge – Although we’re creeping closer, we still haven’t nailed down our second point of confusion about what’s an effective and realistic hedge.  The clearest criterion for an adequate inflation hedge I found comes from a paper by Bekaert and Wang in 2010:

• “For existing securities to be good inflation hedges, their nominal returns must at the very least be positively correlated with inflation…Nevertheless, hedging may be difficult to accomplish in practice…”

In contrast, a Credit Suisse 2012 report on inflation hedges (based on the work of Elroy Dimson, Paul Marsh, and Mike Staunton) looks for a mere lack of correlation between inflation and real (inflation adjusted) stock returns.  However, as I mentioned in my last post, the use of real returns in the Credit Suisse report biases their analysis toward a conclusion that all assets are poor inflation hedge.  Consequently, I stick with the Bekaert and Wang definition for the rest of this post.  I should also mention that Bekaert and Wang looked at inflation hedging over periods of 1 to 5 years.  So, their approach fits with the shorter time frame that appears most relevant to our search for a real-world inflation hedge.

Academics Already Know That Stocks Are A Poor Inflation Hedge

This brings us to the third and last argument: academic research established long ago that stocks are a poor inflation hedge.  First, a brief perusal of the internet reveals an ongoing academic debate on this subject.  One example is from an article by well-known researcher Jeremy Siegel called “Stocks:The Best Inflation Hedge”.  Siegel is often portrayed as perennially biased towards stocks.  But here’s another example discussing the view of North Carolina State University Finance professor Richard Warr, where he says:

• “Most investors fail to appreciate stocks’ ability to hedge inflation because they confuse nominal and real earnings growth — a behavioral trait that economists refer to as ‘inflation illusion’.”

Second, if the inflation hedging ability of stocks is a dead and buried issue, it makes me wonder why researchers like Bekaert and Wang, Dimson et al., Warr, and others are still chipping away at this question as late as 2012.  Most researchers like to discover new concepts rather than merely verify established theories.  Nevertheless, we can explore this recent research to decide how settled the issue really is.

Using our definition from Bekaert and Wang, assets with returns that are positively correlated with inflation over shorter periods like 1 to 5 years represent an acceptable real-world inflation hedge.  But even this fairly rigorous criterion fails to compare various investment assets to each other.  A mindful outlook clarifies that many situations exist on a continuum between “good” and “bad”, or they can be “good” in one circumstance and “bad” in another.  Therefore, we should also compare the relative inflation hedging ability of one asset to another.

I found many old and new studies using a range of methods to compare inflation hedging of various assets, sometimes with scant explanation of the methods employed.  The Bekaert and Wang study is relatively recent (2010) and is one of the most well explained, comprehensive, and detailed studies I found.  Also, because the conclusions of the Bekaert and Wang appear to be broadly representative of most of the other recent studies I found, I use their results below to compare the inflation hedging ability of several investment assets.

Bekaert and Wang calculate a so called “inflation beta”, which is one measure of the correlation exhibited in a time series regression.  Beta is different from the R-squared values I’ve used in earlier posts.  A study by Hewitt Ennis Knupp provides a good explanation of how to interpret inflation beta values:

• “Put simply, when inflation rises by 1 percentage point, an asset with an inflation beta of 1.0 will see its nominal return rise by 1 percentage point as well.  Such an asset would be free of inflation risk, as its returns would rise and fall with inflation.”

Further, a negative inflation beta means that nominal returns decrease as inflation increases.  Using the Bekaert and Wang hedge definition, assets with negative betas are poor inflation hedges.

Total Inflation Hedge – The following graph summarizes one-year inflation betas calculated in the Bekaert and Wang study for several commonly available investment options across 45 countries.  (Their study also calculates betas for periods up to 5 years, and although the longer period results vary somewhat from the one-year results, the overall conclusions are largely the same.)  The data used in their analysis span time frames between 1970 to 2010, although for some regions and countries, the available time period is considerably shorter.  Each world region is represented by a dot.  The error bars (based on standard errors) roughly estimate of how much each beta value could reasonably vary due to noise in the data.

The graph is based on so called “total inflation” for reasons that will become apparent when I talk about “unexpected inflation” below.  The first thing that jumps out is the large spread of regional results and the associated errors around the estimates.  Across all the regions examined, stock inflation betas could reasonably range from 1 (a great inflation hedge) to -2.5 (a poor inflation hedge).  Nonetheless, the center of this spread for stocks is somewhat negative, as approximated by the North American inflation beta of -0.42.  It’s also notable that even relatively large and stable developed stock markets can have positive inflation betas, as shown by the European Union (EU) inflation beta of 0.27.  Further, Bekaert and Wang point out:

• “The inflation beta in the United States is indeed negative but it is not statistically significantly below 1.  In fact, the coefficient became less negative by adding the recent crisis years, in which low stock returns and below average inflation went hand in hand.”

Recognizing all the uncertainty involved, stocks have roughly the worst range of inflation hedging betas among these assets.

The finding that bond betas are slightly better (more positive) than stock betas is somewhat surprising.  In contrast, bonds came out as worse hedges than stocks in the Credit Suisse report as well as a report summarized by Early Retirement Now.  Apparently, differences in data sets, time periods, and methods can yield substantially different answers.  This is one clue that the relationships between asset returns and inflation are not as stable and pervasive as sometimes implied.

Unexpected Inflation Hedge – This next graph focuses on so called “unexpected inflation” betas from Bekaert and Wang.

Unexpected inflation is the part of inflation that’s not already “priced into” assets as part of normal market dynamics.  Researchers have long posited that an inflation hedge could be more useful if it reacts particularly well to “surprise” changes in inflation.  In earlier articles, I’ve referred to these inflation surprises as the “true risk” of inflation.  Nonetheless, extreme attention to only the “unexpected inflation” results could be misleading.  Bekaert and Wang point to a classic 1977 paper by Fama and Schwert, where they used both total and “unexpected inflation” betas to find the best inflation hedging assets.

In my view, the real value of my investments are determined by the total rate of inflation, not just the “unexpected” part of it.  For me, an ideal hedge would address total inflation, which is composed of both routine inflation and “unexpected inflation” not just one or the other.  When total inflation is high, I’d prefer to have access to higher returns, regardless of whether everyone originally expected inflation to rise substantially or not.

I’m even more suspicious of the “unexpected inflation” betas here, because the authors had insufficient data to calculate “unexpected inflation” for all these different regions and time periods.  Instead, they assumed that markets generally expect existing rates of inflation to continue into the future.  They defend this assumption at some length, but regardless, the “unexpected inflation” in this case is really just the change in inflation over the period analyzed.  For example, if inflation was 2% at the start of the period and 2.5% at the end, they assumed that “unexpected inflation” was 0.5%.

Setting my suspicions aside, the “unexpected inflation” betas better differentiate the hedging ability of the assets, although there are still very large and overlapping uncertainties among the assets.  Again, stocks fare the worst, while gold looks relatively compelling as a hedge against “unexpected inflation”, particularly in North America.

And the Winner Is…

The Bekaert and Wang study concludes that broad swaths of stocks are often a poor inflation hedge relative to other assets, which is generally consistent with most of the other academic papers I found.  But as I noted above, the ranges of these outcomes is highly overlapping.  For example, real estate in North America looks like a good total inflation hedge (beta about+2), but with a huge range of uncertainty (from about +6 to -2) just for that one time and place.  Even the gold total inflation betas in North America range from +3 to -0.2.  In comparison, North American stock betas have an uncertainty ranging from about +0.4 to -1.2.  So, it’s entirely possible that real estate or gold in North America might fail to provide a better inflation hedge than stocks in the future.

Media articles too often fail to explain that these type of research findings aren’t certainties, but literal probabilities that are sometimes statistically insignificant.  In most scientific fields, the insignificant negative correlation between U.S. stocks and inflation would not be actionable.  In fact, if you point to any one colored data point in the total inflation beta graph, in almost no cases will that data point lie outside the range of beta uncertainties for the other assets.  This is largely true for the “unexpected inflation” graph as well.

While you can say that gold is the “best” inflation hedge and stocks are the “worst”, such a conclusion completely ignores the uncertainties of the data including the variability over time and place.  While media articles can elevate these conclusions to dogma, a close look at any of these research papers yields important qualifications like:

• Credit Suisse 2012 – “We show that such standard securities [stocks and bonds] are poor inflation hedges.  When we expand the menu of assets to Treasury bills, foreign bonds, real estate and gold, matters improve but mostly only marginally.”
• Bekaert and Wang 2010 – “…[I]t is difficult to protect a portfolio against unexpected inflation in the long term as well using traditional asset classes.”
• Hewitt EnnisKnupp 2012 – “..[T]raditionally recognized “inflation-hedging” assets offer…limited benefits.

Further, the Bekaert and Wang study attempted to devise ideal inflation hedging portfolios by combining various sets of assets, but they couldn’t generate any portfolios that delivered a positive correlation with inflation.  They go so far as to say:

• “In short, it is next to impossible to use an individual asset or a portfolio of assets to adequately hedge inflation risk.”

So, stocks are a “poor” inflation hedge by this measure, but so is pretty much everything else.

Balancing Inflation Risks and Returns

None of my discussion in this series of posts confuses assets as an inflation hedge with holding assets to achieve adequate long-term returns.  But here’s the problem.  No one invests in anything only because it’s a hedge.  The bedrock goal of all investing is to grow the real value of your assets over the long term.  If you don’t achieve that goal, then your portfolio is an unqualified failure.  Although we don’t want to confuse hedging with long-term returns, ignoring those returns would result in some pretty stupid decisions.

For example, the Bekaert and Wang inflation betas suggest that an all-gold portfolio would be the best of a bad lot to hedge inflation.  The Credit Suisse report notes that an all-gold portfolio has provided a 1% annualized real return since 1900.  In contrast, stocks provided an annualized real return of 5.4% in this period.  Using these annualized rates, if you invested $10,000 in each asset for a 40 year investing period, you’d have an inflation-adjusted $82,000 in stocks but only $15,000 in gold.

As many of these researchers point out, balancing inflation “risk” with returns is actually the very same problem as trying to balance volatility risk with returns.  The more you obsess with reducing portfolio volatility, the more your long-term returns and investment goals will suffer.  When an investor balances volatility and returns by selecting a 60%/40% stock/bond portfolio, no one accuses them of confusing volatility for returns.  This observation reveals that the argument about confusing inflation hedging and long-term returns is a bit of a red herring.  Accordingly, a mindful investor must prudently balance short-term inflation impacts with long-term returns.

You could take an all-stock portfolio and hedge it by converting 30% of the portfolio to gold.  Using the annualized real returns for gold and stocks noted above, such a portfolio would have 4.1% in annualized real return as opposed to the 5.4% return for the all stock portfolio.  Reducing your short-term inflation “risk” through hedging has a tangible cost in the form of substantially lower long-term returns.  In this example that cost is 1.3% less in total annualized returns.

In earlier articles, the mindful conclusion was that short-term volatility is mostly just an issue of emotions, and the true investing risk is the potential for a long-term permanent loss.  As a result, most investors benefit from a stock-heavy portfolio.  Likewise, tailoring your portfolio to decrease the impact of short-term inflation gyrations may make you “feel” better, but it will cost you some of your long-term returns.  A stock-heavy portfolio may not technically be the best hedge against inflation, but it’s still the best bet for most long-term investors.

TIPS to the Rescue

While it sounds like hedging for inflation is nearly impossible, many researchers including Bekaert and Wang have observed that Treasury Inflation Protected Securities (TIPS bonds) provide a good inflation hedge, which agrees with past Mindfully Investing posts.  TIPS provide explicit inflation hedging by adjusting the principal and interest rates of a regular U.S. Treasury bond by the annual inflation rate, measured by the Consumer Price Index (CPI).  TIPS will typically outperform similar duration Treasury bonds when inflation is positive, and under perform Treasuries during deflationary periods.  Like other researchers, Bekaert and Wang found that TIPs, and similar bonds available in some countries, are probably the only predictable inflation hedge readily available.  Increased return during increased inflation is literally built into these investment instruments.  However, because TIPS also under perform stocks, adding TIPS to a stock portfolio is still going to cost you some long-term returns in most cases.

Conclusions

We need to dispense with the hunt for the unicorn called a “great” inflation hedge.  The best we will likely ever do is a “decent” inflation hedge.  If a “great” inflation hedge really existed, everyone would use it, which in turn, would probably cause such a hedge to stop working.  This is the reason I’ve been using phrases like “decent hedge”, “sporadic hedge”, or “imperfect hedge”, when describing how stocks can hedge against inflation.

While detailed research shows that stocks have a weak negative correlation with inflation, this relationship is not pervasive over place and time, and most researchers recognize the large amount of noise in the data.  This noise means that while stock returns may sometimes decline as inflation rises, at many other times stock returns hold steady or even rise with inflation.  This noise is  one reason that my simple correlation analyses between U.S. nominal stock returns and inflation in my last post showed that stocks move almost randomly relative to inflation changes.  The mindful perspective is still that stocks are an “imperfect” hedge against inflation.  Better inflation hedges (like gold) probably exist, but they come with the cost of sacrificing substantial long-term returns just to make you feel better about short-term inflation gyrations.

To get past the whole “hedging” argument, I propose we instead say that stocks provide a type of “inflation diversification”.  No reasonable investor expects zero volatility from even the best portfolio diversification.  By the same token, no reasonable investor should expect complete immunity to inflation either.  Because nominal U.S. stock returns have often reacted almost randomly to inflation, stocks are an excellent way to diversify your portfolio for inflation.  Just like with asset diversification, your stock returns are unlikely to consistently increase when inflation rises, but those returns won’t likely be entirely driven by inflation changes either.

Going further, the Credit Suisse report points out that if you add international stocks to your portfolio, you are also getting currency diversification.  Because not all currencies inflate and deflate in lock step, international stock exposure can push the inflation beta for your stock portfolio in a positive direction.  This is very consistent with the Mindfully Investing recommendation for stock diversification: most people should hold a moderate number of low-cost stock index funds including some foreign funds.

Here’s a simple example.  Using the Bekaert and Wang total inflation betas, the weighted-average betas for two different stock portfolios are:

• Portfolio of 100% North America Stocks: -0.42
• Portfolio of 60% North America, 25% Foreign Developed, and 15% Emerging: -0.16

Let’s be clear that these weighted averages are not the exact betas for these portfolios, which would need a more elaborate calculation.  Nonetheless, they give a rough estimate of how stock diversification can moderate negative inflation betas.  The research discussed at Early Retirement Now suggests that you might be able to achieve even greater inflation diversification by emphasizing certain stock sectors in your portfolio.  That study calculated certain stock sectors in the U.S. as having positive unexpected inflation betas in the 4 to 8 range, although their methods for arriving at these results are cited as “proprietary” and are not well explained.

One last note of thanks to Early Retirement Now and Actuary on FIRE, who are doing their own series together on inflation and investing right now.  Their posts have been very valuable in my research and helped me work through this complex subject.  Please check out their excellent posts on inflation!

My last post dove into the swirling waters of stocks as an inflation hedge.  Today I intend to swim even deeper.  Put on your life preservers, and take your sea-sickness pills.  Here comes a  deluge of data, and the ride is expected to be choppy.  I can’t guarantee it will be all that thrilling, though I have a fair chance of making you queasy by the end.

If you missed my last post, you might want to read the conclusion there to catch up on the whole issue.  In brief, I’ve made the case in the past that stocks provide a useful but imperfect hedge against inflation.  Since then, I’ve come across articles and research indicating that stocks aren’t such a good inflation hedge.   I feel that my last post successfully refuted the evidence presented in one of these articles.  So, climb aboard the U.S.S. Mindfully Investing as we sail once again into the debate surrounding stocks as an inflation hedge.

“Conventional Wisdom” about Stocks and Inflation

Our first destination is an article by Howard Gold in 2012 at MarketWatch titled “Don’t Count on Stocks as an Inflation Hedge”.*  The article starts with:

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

I was a bit perplexed when I first read this, because personally, I’ve seen this conventional wisdom applied to gold investments much more than it’s applied to stocks.  Regardless, Mr. Gold mobilizes three ships to carry his assertion that stocks are a poor inflation hedge:

1.   Stocks and inflation have a “strong” negative correlation, meaning that stocks do poorly when inflation rises.
2.   People confuse the long-term return from stocks with their ability to hedge inflation, which are two different things.
3.   Academic research established long ago that stocks are a poor inflation hedge.

Looking across all the articles and research I’ve read, these three ships are a good synopsis of the most commonly used arguments against stocks as an inflation hedge.  This post will test the sea-worthiness of the first ship, while my next post will examine the last two.

Navigating the Data

The Gold article provides useful links to research supporting the “strong” negative correlation between stocks and inflation.  One link is to a great summary from 2012 about the relationship between stock returns and inflation by Credit Suisse, which is largely based on the work of Elroy Dimson, Paul Marsh, and Mike Staunton.  Here’s one of the most compelling graphs in the Credit Suisse Report.

The graph uses stock and inflation data from 19 countries across 112 years.  It seems to show a negative relationship between stocks and inflation.  As inflation rises, inflation adjusted (real) stock returns decline.  This seems to contradict my own analyses (see here and here) using U.S. S&P 500 data from Robert Shiller, which showed no clear relationship like this.

Why were my past results different from the Dimson et al. research?  To answer that question, I created a similar graph using the U.S. data from Shiller as shown here.

Batten down the hatches!  My new U.S. stock graph looks pretty similar to the Credit Suisse multi-country graph.  Did my previous analysis only see the tip of the data iceberg?  Before I abandon ship on the idea of stocks as a decent inflation hedge, I can’t resist looking below the surface.

To start, the above graph shows that U.S. stocks perform pretty consistently in real terms from moderate deflation (average -4%) to moderate inflation (average +4%).  There’s actually no decline in real stock returns across this most common range of inflation rates.  What’s causing real stock returns to decline somewhere around the 5% inflation threshold?  A look at nominal stock returns instead of real returns could help answer that question.

Removing the inflation correction from stock returns clarifies that stocks have provided relatively consistent average annual nominal returns across a wide range of inflation rates.  There’s no clear negative relationship between the two.  Except for the extreme deflation case, the nominal returns were all within about 7 to 13%, regardless of the prevailing inflation rate.

Typically, if your going to look for a potential correlation between two variables, the first step is to create a scatter plot and calculate a correlation best-fit line.  Going back to inflation adjusted returns, here’s the scatter plot of real returns versus inflation provided in the Credit Suisse report, although for some reason they decided not to show a best-fit line or the level of correlation.

Although I don’t see it, the Credit Suisse authors claim there is a slight downward slope in this plot.  But they also note:

• “Nevertheless, the correlation between the series is only mildly negative and so this relationship must be interpreted with caution…There is a tremendous degree of return variation that is unrelated to inflation, reflecting the substantial volatility of equity returns.”

They resist saying it, but put another way, the negative correlation between real returns and inflation is actually poor.  To verify that, here’s my graph using U.S. real stock return and inflation data.

For U.S. real stock returns, the correlation with inflation has a paltry R-squared value of 0.13.  (R-squared is the “coefficient of determination” and shows how close the data are to the fitted regression line.)  In my past work in environmental science, we like to see R-squared values above 0.3 before we would consider one variable potentially predictive of another.  In my experience, the level of correlation between U.S. real stock returns and inflation is almost meaningless.  Just to see what happens, let’s again dispense with the inflation correction and plot the same data using nominal returns.

Once again, the apparent relationship disappears using nominal stock returns.

Math to the Rescue

There’s an obvious math problem lurking below the surface that is rarely mentioned in the articles and research I found.  A few sentences in the 64 page Credit Suisse report make brief note of this problem:

• “We are estimating a relationship between real returns and inflation.  Inflation therefore appears in the regression both as an independent variable and (indirectly) as a component of the dependent variable…so the partial hedge indicated by [these data] may understate the hedging ability of the assets…” (my emphasis added).

Specifically, when you calculate real returns from nominal returns, the inflation rate is in the denominator.  The dependent variable (returns) becomes a function of the independent variable (inflation) in the correlation.  Here’s an example of nominal returns and inflation rates where I had a computer randomly select values between 0% and positive 20% for each variable.  The top graph uses nominal random returns and the bottom graph uses real random returns (which I called “normalized”).

Converting to real returns creates an instant correlation!  I ran this random simulation 20 times just to make sure the above graphs were not outliers, and the average nominal R-squared value was 0.01 and the average real R-squared was 0.50.  So, the above graphs aren’t a fluke of random number generation.

Math tells us that looking at the relationship between real returns and inflation is double counting the inflation variable.  The fact that the correlation between the two is so low for U.S. stocks indicates that stock returns are indeed highly variable, as Credit Suisse mentioned.  I’d argue that a much cleaner way to look at the relationship between returns and inflation is to use only nominal returns.  After the analysis is done, it would still be reasonable to consider how the real value of the stock returns under various inflation conditions might impact your investment plans and goals.  But including real returns in the analysis upfront muddies the waters, biases the results towards negative correlation, and inherently favors a hypothesis that stocks are a poor inflation hedge.

Cruising Upstream

Let’s look again at a bar graph of real returns broken down by percentiles of historical inflation rates.  But this time, let’s examine how stock returns versus inflation contribute to the real returns as shown in this graph.

The orange bars are just the same real returns shown in my first bar graph in this post.  The blue bars take the all-time nominal Compound Annual Growth Rate (CAGR) since 1871 (a value of 10.1%) and subtract the average inflation rate for that inflation percentile.  You’ll note that, except for the deflation case (low 5th percentile), the blue and orange bars for each percentile of inflation are nearly the same throughout the graph.  This shows that inflation itself drives the apparent negative correlation between real returns and inflation.  Although stock returns are highly volatile on a year-to-year basis, the overall average nominal returns of stocks, minus the inflation rate for any given inflation percentile, does a pretty good job of estimating the real returns across the entire range of historical inflation conditions.

A good analogy is cruising up a river in a boat.  Nominal returns are the forward speed generated by the boat’s motor when the boat is cruising through still waters.  When the motor is run steadily at a moderate power level, most of what determines the boat’s net rate of progress upstream (real returns) is the velocity of the opposing water currents (inflation), not the output of the motor (nominal returns).  If the currents against the boat are strong enough (high inflation), the boat actually makes no forward progress and will be pushed back downstream (negative real returns).  If the currents are travelling in the same direction as the boat (deflation), then the currents assist the boat’s forward progress (augmented real returns).

Of course, in real life, the motor of nominal stock returns is not steady.  As noted in the Credit Suisse report, stock returns fluctuate wildly, which makes it difficult to differentiate inflation from other factors effecting returns at any given time.  Because these other factors are myriad and complex, for most investors, variations in stock returns appear essentially random.  And the data show that these random variations mostly overwhelm any potential correlation between nominal returns and inflation.  Random chance means that stock fluctuations can sometimes coincide with inflation changes and sometimes not.

Leveraging the Data

I wondered if part of the problem with the poor correlation between the S&P 500 nominal returns and inflation might be due to the use of annual average returns, which limits the data set to just 147 points, one for each year of the entire history since 1871.  More importantly, using annual returns assumes that all results are from a one-year investment period, but almost no one actually invests in stocks that way.

I was curious if annualized nominal returns (CAGR) over various investing periods might better represent real-life investors and show a better correlation with concurrent inflation rates.  So, I calculated the CAGR and geometric inflation rate for all possible investing timelines since 1871.  Each calculated data point represents starting and ending a stock investment at different times.  Thus, one point represents investing in the period from, for example, 1871 to 1995.  Another point represents, for example, a period from 1871 to 1900.  Yet another point represents 1972 to 1982, and so on.  This process is repeated until every possible long (up to 147 years) and short (down to 1 year) investing period for the entire S&P 500 stock history is calculated.  Here’s a scatter plot of the more than 10,000 data points generated by this process.

It’s still looks random to me.  And if anything, there is a slight positive relationship between nominal annualized returns and annualized inflation, though the correlation is very weak.  It seems unlikely that the stock returns for any group of real-life investors, who invested at different times and over different periods, would be predictably related to the inflation rates occurring during their varying investing periods.

Conclusion

Closely examining the correlations between stock returns and inflation reveals a few leaks in the ship of “strong negative correlation” that is often mobilized in this debate.  Both my simple analysis and many of the details in the Credit Suisse report show that the apparent negative correlation is not that clear or strong.  Instead we see a weak negative correlation using real returns and a lack of correlation using nominal returns, which means nominal returns are essentially random relative to inflation.

Using the boating analogy, many people seem to argue that the poor relationship between returns and inflation means that there’s no experienced boat pilot prudently revving up the motor of nominal returns when inflation currents increase; this makes stocks a poor hedge against inflation.  Instead, the motor of nominal stock returns seems to be operated by a drunken novice who fluctuates the motor’s output based on personal whim.  Because of our drunken pilot, one could equally argue that stocks are mostly independent of inflation.  Therefore, stocks can often resist the ebb and flow of inflation currents.

It seems to me that the first ship of “strong” correlation is swamped, although not quite sunk to the bottom.  Unlike the Credit Suisse report, I didn’t look at data from any countries beyond the U.S.  However, given that the U.S. represents more than half of the world stock market size, it seems like an analysis of U.S. data is more relevant to most investors than an analysis that includes developing countries like South Africa, India, etc.

In my next post, I’ll conduct leak inspections on the last two ships in this debate: 2) confusing long-term stock returns with their inflation hedging ability 3) the established academic research indicating stocks are a poor inflation hedge.

 

* It’s interesting that almost all the articles I found on this subject were written right around 2011 to 2012, when everyone seemed to be worried that inflation was about to accelerate and swamp their investment portfolios.  In fact, inflation rates declined a little in the ensuring years, which shows, once again, the difficulty of predicting the future.

I wrote a post last year about inflation and investments, where I concluded that stocks are a useful but sporadic hedge against inflation.  This was based on a fairly robust analysis of past U.S. stock returns and inflation rates going all the way back to 1871.  I found that stock returns were uncorrelated with inflation rates.  Further, stocks often provided decent returns after large spikes or dips in the inflation rate, even though one might assume these sorts of economic conditions would consistently spook investors out of the stock market.

I was pretty confident with my conclusions until I came across several articles that claim stocks are, in fact, a poor hedge against inflation.  Could my analysis have been all wrong?  I hate being wrong, so I conducted a more laborious analysis of stocks and inflation.  The time involved with this analysis is one of the main reasons it’s been so long since my last post.  Apologies to my regular readers, as few as you may be.

Why Should We Even Care?

The whole question of stocks and inflation may seem esoteric.  However, many investing gurus are concerned that current trends in strong corporate earnings, low unemployment, and wage pressures will lead to a new period of rising inflation.  Mindfully Investing recommends a stock-heavy portfolio for almost all individual investors.  So, if stocks aren’t a good inflation hedge, then that’s timely and potentially actionable news for us mindful investors.

One of the key tenants of mindful investing is patience, and exploring arcane but important topics like this can test that patience.  Despite the high boredom potential, I’m planning a series of posts to pull apart the Gordian knot of stocks as an inflation hedge.  If you’re feeling sleepy already and have developed some trust in Mindfully Investing, you could just skip to the conclusion at the end of this post.  And you can do the same when my follow-up posts on inflation and stocks come out.

Look What Happened in the 1960s

The first article that started me reassessing stocks as an inflation hedge was at Financial Times by Mathew C. Klein entitled, “No, Stocks Aren’t a Good Inflation Hedge. Try Bonds (Really)”.  The article presents an analysis of stock and bond returns during a period of increasing inflation in the late 1960s and early 1970s.  Beyond the hippies, drugs, free love, questionable fashions, civil rights, feminism, war, and the associated political shenanigans, this was also a tumultuous economic period.  Here’s the key figure from the Klein article.

The graph shows that from about 1964 to 1970 (circled in red) the annualized S&P 500 stock return slightly under performed the U.S. 10-year bond returns, assuming both investments were held for 10 years.  The annual inflation rate increased from about 1% to 6% in this period and continued up to 12% a few years afterwards.  Klein writes, “If [in 1964] you had known that the US was about to experience a long period of accelerating inflation, would you have bet on US Treasury bonds over US corporate equities?  It certainly doesn’t seem like the right plan, and yet [bonds] would have made you money for a surprisingly long time.”

First, let’s be clear on Klein’s point.  My last post on inflation presented considerable evidence that stocks can perform well during high inflation or deflationary periods, and Klein’s prudently not challenging that generic idea.  Here’s one graph from my last post illustrating the resilience of stocks during a wide range of inflation conditions; it’s based on data from Nobel Laureate Robert Shiller spanning 1871 to present.

Instead, Klein claims that the 1960s illustrate how bonds combat inflation better than stocks specifically during periods when inflation is rising substantially.  However, just my simple graph shows several exceptions when inflation was rising but stocks performed pretty well.  And it’s even hard to detect in my graph the supposed miserable performance of stocks in the late in 1960s, but if I squint, I kind of see Klein’s point.

Second, Klein is focused on the ramping inflation that was in store for someone investing around 1963 or 64.  While Klein’s graph looks compelling, it doesn’t give us any information on inflation rates.  It seems that a closer examination of both stock returns and inflation in the 1960s could clarify whether this weird time in U.S. history proves that stocks are a poor inflation hedge in general.

Stock Returns and Inflation from 1965 to 1975

This table shows the Shiller data from 1960 to 1980, which includes the decade from 1965 to 1975 plus five additional years on both ends to provide little wider perspective.

Whether you focus on nominal or real returns, stock investors experienced some really good and some really bad years over this period.  This was not a time of consistently dismal stock returns.  The results for any given investor were heavily dependent on exactly when they entered and exited the stock market.   Inflation jumped around quite a bit too, which belies the generalization that inflation was steadily increasing.

To estimate what an actual investor might have experienced, I calculated all possible combinations of start and stop years for a stock investor in the decade from 1965 to 1975.  Specifically, I calculated the Compound Annual Growth Rate (CAGR) of stocks and inflation if you started investing in 1965 and ended in 1966, 1967, 1968, etc.; started in 1966 and ended in 1967, 1968, 1969, etc.; and so forth.  This method produces 66 investing periods ranging from 1 to 10 years long, with the longest period representing the entire decade from 1965 to 1975.  The median duration across all 66 investing periods is just 4 years long.  At Mindfully Investing we generally advise investing in stocks for periods longer than 5 to 10 years.  So, the results for these 66 periods represent a relatively risky investment strategy during a pretty risky decade.

Despite the short timelines involved, this histogram of all the results shows that 80% of the 66 outcomes produced positive nominal annualized stock returns and about 40% produced returns above 5%.

Here are the same results on a real basis (adjusted for inflation), which shows that 40% of the 66 outcomes yielded positive real annualized stock returns and about 25% had real returns above 3%.  Perhaps more importantly, only the worst 10% of the results produced real losses lower than an annualized -10%.  And these worst-case outcomes all involved investing over very short periods of about 1 to 2 years; longer investing periods fared much better.

Although the most likely outcome was a slightly negative real return, during this period of rising inflation an investor still had a pretty good chance of achieving positive real stock returns.  And you had a low chance of a significant loss, despite the short timelines involved.

Extrapolating from the Example

Don’t get me wrong, the period from about 1965 to 1975 was pretty bad for stocks.  Using more standard measures, if you held your stocks for the full decade and then one more year into 1976, your annualized real return was essentially zero (although the nominal annualized return was about 5%).  And as Klein’s graph shows, bonds barely outperformed stocks in the first half of this decade, and stocks resumed outperforming bonds by a much wider margin in the second half and beyond.  So, it’s not like bonds represented a huge missed opportunity for the long-term stock investor.

In comparison, Klein’s graph shows the decade from 2000 to 2010 was miserable for stocks, even though inflation was uniformly low.  I held stocks throughout that decade, and the S&P 500 generated a paltry real annualized return of -1% (nominal +1%), but nobody points to inflation rates as the cause.  Klein’s graph shows that 1929 to 1932 was even worse for stocks.  But economic conditions leading to deflation were the problem in the early 1930s, not ramping inflation.

If anything, the ramping inflation in the 1960s and early 70s seems coincidental to stock performance in this period, with both reflecting larger economic troubles.  And despite those economic conditions, my analysis shows that stocks were still a pretty effective investment for many investors, depending on exactly when and how long they were invested.  Klein even points out that stocks were “so expensive” in the 1960s, which would seem to be a more direct, although less illuminating, reason for the stock market’s poor performance.

Conclusion

I don’t think Klein is willfully misrepresenting or cherry picking the data.  Bonds did in fact outperform stocks for a few years at the start of this period of rising inflation.  However, I think Klein made a leap that one example proves a rule and another leap that a short-term correlation implies a larger causation.  I continue to think that the 1960s were one episode that’s fairly consistent with the longer history of stocks and inflation, and that history suggests that stocks can be a useful but imperfect hedge against inflation.

After stepping back from these details, I realized that much of my disagreement with the Klein article probably boils down to the title.  To better attract clicks, internet titles tend to be somewhat hyperbolic and absolute.  In particular, it seems clearly false that bonds were a better hedge than stocks in this period, just by the simple fact that bonds only outperformed stocks for three years in this window, and only then by a very slim margin.

No investor can predict the future.  Dumping stocks in favor of bonds in the mid-1960s, or any time when inflation looms, seems like a highly imprudent “hedging” strategy for long-term investors.  Such a strategy ignores the copious evidence that stocks have handily outperformed bonds under a very wide range of historical market and economic conditions.

I also think part of the problem may be the widespread but vague use of the term “hedge”.  I’m somewhat guilty of that myself.  You can find a range of definitions for “hedge”, and in everyday usage, its meaning expands to cover almost anything other than a strong positive correlation between two metrics.  I’ll explore the confusion around inflation “hedges” in my next posts in this series.

Unfortunately for me, the Klein article is not the only one I found arguing against stocks as an inflation hedge.  In fact, some of these articles led me to quite a bit of scholarly work questioning stocks as an effective inflation hedge.  Reality checking this information involves an additional level of analysis that I’ll leave to my next post.

I just added a new Article 8.6 – “The Problem of Inflation” to the Mindfully Investing series on Investing Over Time.  The central concepts from the article are covered in this post.

Inflation is a prominent player in any evaluation of investing over time, because inflation is a time-dependent process just like compound returns and market gyrations.

Inflation defined

In short, inflation is when the prices of goods and services rises over time, which means the “purchasing power” of your money is falling.  A Big Mac may be priced at about $4.00 today.  But if the cost of the Big Mac ingredients (beef, flour, lettuce, etc.) and the labor (hourly wages) to make the Big Mac go up by 3% a year (for example), the price of a Big Mac may be $4.15 next year.  It’s the exact same Big Mac, but next year you might need an extra $0.15 to buy it.  Your $4.00 can’t buy quite as much as it used to; it’s “purchasing power” has gone down.

The inflation problem

An extra $0.15 for a $4 purchase doesn’t sound particularly alarming, even if you apply it to every purchase you make next year.  But the problem becomes more apparent if you start to consider the compounding of annual price increases over many years.  Over these time spans, the dreamy miracle of compounding returns turns into a nightmare when it comes time to spend those returns on something in the real world.  As shown in this graph, all the while your investments are compounding, so are the prices of goods and services thanks to inflation.  And the longer compounding works, the greater the increases in both returns and prices.

In this example, if you had invested $1 in government bonds in 1926, you’d have about $23 now (red line).  But during that same 90 years, something that was priced at $1 in 1926 is now priced at about $13 today (gray shading).  In other words, you could buy almost three pounds of cheese for one dollar in 1926, while today you need around $5 to buy just one pound of the same cheese.  Well, not the exact same cheese, because that would be incredibly hard and moldy by now.  That 23 times increase in your bond value is a mere 1.8 times increase when the declining value of a dollar is factored into the analysis.  Taking more than 90 years to only double your money seems like a pretty dismal investment plan.  How can we do better?

Inflation and investing

In Article 6.2 I noted that most estimates point to a future 4 to 6% annual average return for stocks on a non-inflation adjusted basis, and more like 2 to 4% when inflation is considered.  A couple of percent difference between nominal and real return may not sound like a lot, but it has a huge effect over time.  Here’s a graph I created using Robert Shiller’s data comparing compound returns in the S&P 500 on nominal and inflation adjusted real basis (orange and gray lines).  The yellow bars show how inflation varied over time and contributed to the divergence of nominal and real returns.

The idea of turning 1$ into almost $320,000 sounds a lot more compelling than the bond growth scenario discussed above.  But again, the real result is closer to only $17,000 when the purchasing power of those dollars is considered.  That’s $303,000 dollars in potential return vaporized because of inflation.  This graph also illustrates that when inflation is sporadic or negative (called deflation), like it often was from 1871 to about 1931, the nominal and real stock returns aren’t that different.  When inflation is consistently positive, like 1940 to today, the nominal and real return lines diverge rapidly.  In real terms, stock performance over time can be mostly explained by inflation rates alone, even if you regard yourself as a particularly good stock picker.

Media articles often assert that inflation makes bonds a “bad” investment or cash a “terrible” investment.  One of the most important points that is often left unmentioned is that inflation impacts all investments essentially equally.  If you like to think in mathematical terms, the “Fisher” equation for calculating real (inflation adjusted) returns makes it completely clear that all investments are effected equally by inflation.

In this case, RN is the nominal (non-inflation adjusted return) and RI is the inflation rate.  The exact same equation is used for stock, bond, and cash returns.  You can plug-in the inflation rate and annual nominal return for any investment and get RR, the real (inflation adjusted) return.  So, if your stocks returned 8% last year, and the inflation rate in that year was 3%, your real rate of return was 4.854%.  You’ll note that 4.854% is approximately equivalent to just taking 8% (the nominal return) minus 3% (inflation rate), which equals 5% (the approximate real return).  People often use this simple subtraction method to obtain a quick estimate of the real return.

This table provides both the exact and quick estimates of real returns using a 2% annual inflation rate and expected future nominal returns for stocks, bonds, and cash as presented in Article 6.2.

Investment	Nominal Expected Return	Real Expected Return Fisher Equation	Real Expected Return Quick Estimate (RN-RI)
Stocks	5.0%	2.94%	3.0%
10 Year Bond	2.3%	0.29%	0.3%
Cash	1.2%	-0.78%	-0.8%

Inflation takes the same bite (2% in this case) out of every investment type.  No return is entirely safe, and no return does “better” than the others at avoiding this inflation bite.  If you pick investments that produce returns lower than inflation, then you will lose money in real terms.  If you pick investments that produce returns higher than inflation, then you will make money in real terms.  It’s really that simple.

Inflation “risks”

Another thing you will often hear from the media and professional advisers is talk about inflation “risk”.  The term “risk” is loosely used in different ways and with different meanings.  Risk is often misunderstood as a concept, and therefore, the term is overused and even abused.  The assessment of risk, and the subsequent concept of risk management, was born out of the nuclear power and space exploration industries.  In this context, a risk is not anything bad that you can imagine, but rather, it is an uncertain or infrequent event that could cause substantial harm.  For example, a space rocket designer might want to consider the risk of a one-time failure in a specific reusable rocket booster seal, which was the cause of the Challenger space shuttle disaster in 1986.  In the investing world, a similar type of risk might be subprime mortgage lending practices leading to a stock market crash in 2008.

In contrast to a classic risk factor like a rocket seal failure, inflation is a predictable and more or less continual process that impacts all investments equally.  The last graph shown above makes it clear that, particularly since the 1940s and the development of modern monetary policies, inflation has occurred continually with some variation in magnitude.  In this sense, inflation is not a classic risk factor, and is poorly addressed through risk management.  Inflation is more like the expected corrosion in a rocket booster nozzle over time.  In cases like these, engineers know the nozzle materials they use will corrode and degrade after repeated usage, and they know that no material is entirely immune to this process.  So, instead of treating these continual processes as uncertain risks, engineers build in operations and maintenance procedures to track, minimize, replace, and correct material degradation problems before a disaster occurs.  For an investor, inflation is much more of an operations and maintenance problem than an uncertain “risk”.

There is no “risk” of inflation, because the continued existence of inflation (or deflation) is a near certainty.  The only time it probably makes sense to talk about inflation “risks” is when considering the possibility of sudden and large changes in the inflation rate.  One example of an inflation risk might include a rapid swing from inflation to deflation as occurred multiple times in prior to the 1920s.  Another example might be a sudden large increase in inflation from moderate to extreme levels as occurred in the 1970s.  These unexpected and infrequent swings in inflation should be considered when investing, because they may seriously impact your portfolio.

Mindful investing for true inflation risk

To guard against true inflation risks (rapid and unexpected swings in inflation rates), we need to look at the history of inflation versus stock, bond, and cash returns.  History is never going to predict the future exactly, but it’s often some of the best empirical data available.

Bonds – This graph compares the 10-year bond yield (blue line) and Federal Fund Rate (FFR; redline) to inflation rates since 1960.  The FFR is a reasonable proxy for cash interest rates, such as a 6-month certificate of deposit.

Essentially, bonds (and cash) yields go up and down with inflation.  This is because nobody wants to put their money in a “safe” investment just to find out they lost money in real terms at the end of the process.  Rising inflation usually causes higher bond yields but lowers bond prices.  The cumulative effect is that bond returns suffer during inflation increases.  However, even in this situation bond funds almost always provide a positive return (if held for their duration) because bond yields and inflation rise together.  Sudden decreases in inflation usually cause the opposite reaction, where bond yields decline and prices increase.  Declining inflation more clearly favors bonds as prices increase on bonds that have favorable current yields.  This is the process that drove the great bond bull market from the 1980s to present.

This is not to say that bonds are a perfect hedge against rapid changes in inflation.  There are certainly shorter historical periods where bonds did very poorly.  But as this graph illustrates, bonds have usually been a safe (albeit unspectacular) investment over huge ranges of inflation conditions and fluctuations.

If you hold bonds (or bond funds) for their duration, history indicates that you’ll rarely lose significant real value over time.

Cash – The story of cash and inflation is similar, but not exactly the same as the bond story.  Cash should be a short-term investment because, regardless of whether you factor in inflation or not, cash generally provides a poor return.  Cash interest rates will move up and down with inflation as shown above.  So, over the short-term, it’s rare that you will have huge real losses in an interest-bearing cash account or short-term CD due to inflation changes.  For example, if inflation rises rapidly this year and your low-interest 6-month CD matures, you can usually plow that money back into another 6-month CD offering a higher interest rate.  Regardless, over longer periods, you will get better returns from bonds and stocks.  But there are times, like right now, where cash is nearly as good as bonds, and can be used just as effectively as bonds for the short-term ballast portion of your portfolio.

Bonds, cash, and true inflation risk – This information on bonds and cash gives us new insight into how to manage the true risk related to inflation, which is rapid and unexpected changes in inflation rates.  For example, if inflation did suddenly and unexpectedly flare up next year, our mindful conclusions about using cash instead of bonds for short-term ballast would likely be entirely different in that environment.  For example, as shown in the graph at the start of this “bonds and cash” section, investing in a constant maturity 10-year T-bond fund in 1982 (if such a thing existed then), would have been a phenomenally good idea.  That’s because the 10-year T-bond yield levitated 2% to 8%(!) above the rate of inflation for 20 years until about 2005.

Treasury Inflation Protected Securities (TIPS) bonds are likely to provide a particularly good hedge against the true risk of unexpected inflation rate increases.  TIPS provide this inflation protection by adjusting the principal and interest rates of a regular U.S. Treasury bond by the annual inflation rate, measured by the Consumer Price Index (CPI).  TIPS will typically outperform similar duration Treasury bonds when inflation is positive, and under-perform T-bonds during deflation.

Stocks – Unlike bonds and cash, stock returns are not clearly correlated with inflation, as shown in this graph I created using changes in the Consumer Price Index (CPI) and nominal S&P 500 returns from Robert Shiller’s data.

Importantly, stocks provided positive nominal returns in many times when inflation was both positive and negative, even strongly so.  This tells us that stocks can do well in times of inflation and deflation, but the primary risk we are concerned with are sudden changes in inflation rates.  So, I broke these data down even further and examined just stock returns in the same years when inflation rates changed more than 4% (either up or down).

And given that stock reactions may not be instantaneous with inflation changes, I looked at the next year’s stock returns as well.

In both cases, there is no correlation with rapid inflation rate changes and subsequent stock returns.  In fact, these rapid inflation changes occurred 53 times in the past, but only in 13 (same year) or 12 (next year) cases were the subsequent nominal stock returns negative.

This means that stocks provide a natural, but sporadic, hedge against the true inflation risk of sudden and unexpected changes in inflation rates.  There are certainly times when rising inflation helped cause relatively poor stock returns for prolonged periods, such as in the 1970s and early 80s.  But history tells us that more often, stocks have provided a hedge against rapid inflation changes.

Mindful investing for routine inflation

For routine ongoing inflation, a mindful perspective takes us back to the simple determination that you want to invest in assets that provide returns beyond the expected rate of inflation.  As shown in the above table, stocks are currently the only one of the three major asset classes (stocks, bonds, and cash) expected to have significant positive real returns.  Thus, a stock heavy portfolio appears prudent for most investors right now.  This is another way of expressing the same mindful conclusion we reached in the Article 7 series.  This conclusion remains true considering the other risks associated with stocks, which I defined in prior articles as not routine volatility, but the relatively moderate risks of permanent losses over a long-term investing time frame.

This graph of S&P 500 nominal return data minus the CPI inflation rate (the virtual definition of real returns) illustrates this conclusion.  That is, nominal stock returns tend to outpace inflation in most years, although there are certainly lots of exceptions.

We can further confirm the conclusion of “stocks over bonds” for investing in most inflation periods by looking at the real returns of long-term treasury bonds versus the total U.S. stock market starting at the unprecedented and long-lived bond bull market starting in 1982.  This graph from Portfolio Visualizer presents the comparison with stocks shown in blue and bonds shown in red.

At many points in this very unusual period (like 1988, 1996, 2003, and 2013) long-term bonds would have proven to be just as good a choice as stocks.  But put another way, this also means that stocks were just as good as bonds even under almost ideal conditions for bonds.  And as longer-term graphs show (such as the one all the way at the start of this article), at most times, stocks have handily out-performed bonds over wide ranges of inflation conditions and rates of fluctuation.

Conclusions

We’ve determined that:

• Inflation is a persistent aspect of the modern economy and investing environment.
• Inflation does not preferentially impact one investment type over another.
• To obtain “real” returns our investments must exceed the rate of inflation.
• Right now, stocks are the only investment type likely to substantially exceed the rate of inflation on a consistent basis.
• It’s generally not helpful to think of routine inflation as an investing “risk”.  Instead we can plan for and adapt to this persistent part of the investing environment.
• The true “risk” associated with inflation is sudden and unexpected changes in inflation rates (up or down).
• Bonds provide a reasonable hedge against inflation changes if held for their duration.  Because rising rate environments provide a drag on standard bond returns, TIPS bonds are a particularly good option to hedge against unexpected inflation increases.
• Held for the short-term, cash provides no practical hedge against inflation changes, but it doesn’t necessarily result in substantial real losses.
• Stock returns and inflation changes are historically uncorrelated. Stocks often have positive returns during rapid inflation changes and provide a substantial, although sporadic, hedge against these changes.
• Stocks have also historically performed better than bonds during most periods of routine inflation and kept pace with bonds during ideal bond environments.

Our mindful examination of inflation validates the conclusions from the Mindfully Investing articles that in most cases, stocks are the best option to deal with routine inflation as well as the more infrequent true risk of rapid unexpected changes in inflation.  Having a portion of your portfolio in intermediate TIPs may provide an extra hedge against the risk of rapid inflation increases, exactly because such increases are currently unexpected.   Finally, cash can be a valid substitute for bonds as portfolio ballast, but only if held for relatively short periods.  Inflation and interest rate changes should be closely monitored by the individual investor now and always.  Such rate changes will likely require a re-evaluation of the asset allocation in your portfolio.  For example, if inflation and interest rates increase rapidly soon, it may be prudent to add more bonds to your portfolio or replace cash ballast with intermediate term bonds.