2. The Investor and Inflation

Inflation is a strong motivation for all investors, and the primary motivation for some: the fact that the dollar today has less purchasing power than it held in the past, and will hold even less in future, requires the investor to seek a return that will at least preserve his purchasing power.

The investor who holds a stock seeks to preserve his purchasing power as the value of shares and dividends meet or exceed the rate of inflation in each year, and the one who holds a bond seeks the same goal by means of interest payments.

The interest rate paid on bonds is set according to current interest levels that remain fixed for the life of the bond. It is for this reason many financial authorities believe bonds to be undesirable, as any increase in the inflation rate renders the bond incapable of preserving wealth.

As such, some advisors encourage investors to keep their portfolio 100% in stocks and invest nothing in bonds. However, this is no more sagacious than investing 100% in bonds and avoiding stocks altogether - which yields a certainty of a given level of income, but no hedge against an increasing rate of inflation that would erode the purchasing power of the amount of money invested in bonds.

However, even high-quality stocks are not a better purchase than bonds in all conditions. Where the rate of inflation decreases, a bond provides better returns than stocks. And regardless of what happens with the rate of inflation, the return on a bond has greater certainty of providing a predictable return: so long as the issuing firm remains solvent, it will pay interest and be redeemed in amounts that will not fluctuate with the market.

Predictions of inflation are based on a knowledge of past experience. It is particularly high at the time this book is being written, but there are historical precedents - and while the current trend is an increase, it is likely that it will again decrease, just as it has in the past. On average, the rate of inflation over the period from 1915 to 1970 was 3%, even including periods in which it advanced more rapidly. As such, the holder of long-term bonds needed to earn only 3% to preserve his wealth, even though at specific times he would have earned less than the rate of inflation.

The question that follows is: can an investor be reasonably sure of his returns when buying and holding things other than high-grade bonds? Specifically, it is implied that an all-stock portfolio could earn similar or better returns and adjust more readily to changes in the rate of inflation. The answer to this question is somewhat complicated.

Over long periods of time, common stocks have indeed done better than bonds. Between 1915 and 1970, blue-chip stocks returned an average return of 8% per year (including growth and dividend payments), and some expect that they will continue to do so. The author, however, disagrees: common stocks might do better in future, but there is no certainty they will do so.

The problem with stocks is simply the attitude of the investor: the individual who holds a bond generally does so until its maturity, and gains a certain return as a result, whereas the holder of stocks are more prone to panic over short-term performance, to sell one position and buy another, in a frantic attempt to avoid loss - and in doing so, to diminish his own return. This is not necessarily true, as the investor may choose to hold a given stock even through periods in which a company is performing poorly, patiently waiting for its recovery, but this behavior is seldom witnessed in practice.

What can be said with certainty is there is no direct relationship between the value of a stock and the rate of inflation. This is most obvious in the years between 1965 and 1970, in which inflation rose at a historically dramatic rate while the value of stocks steadily declined. This and similar contradictions in the value of stocks and inflation over the course of the market's history are a clear indication that, whatever factors motivate the change in value of stock, inflation is not among them.

Inflation and Corporate Earnings

The level of economic activity in an economy is derived from the earnings rather of suppliers (companies) in that same economy. As such, the increase in cost of living to consumers results in a corresponding increase in income to those that supply the goods that constitute the consumer's "cost of living."

However, this does not mean that the price of stocks increases with the inflation rate - because the price of a stock is often significantly increased above the actual amount of earnings of the company it represents. That is to say that if a stock price is ten times the earnings of a firm (which his conservative, as some blue-chip issues trade at up to 18 times earnings), 90% of the value of the stock is entirely fabricated, and even if earnings double, this influences only 10% of the amount reflected by the firm's market capitalization.

One might counter that if the earnings of a company double, then the price would double, based on the assumption that it would still trade at price times earnings. Historically, this has not borne out: while the tendency has been for the price of a stock to increase when a company's earnings increase, it has been by a far lesser proportion. That is, price is not fixed at a "times earnings" value. This is among the primary reasons that stocks cannot be counted on to rise in correspondence to inflation rates.

In certain schools of economic theory, it is considered that "a little inflation" is helpful to business profits, as it enables them to benefit from rising prices to earn greater income from selling the same amount of goods at an increased price to consumers. However, this notion runs contrary to the earning power of capital, which is diminished in equal measure - that is, the business that raises the prices of its output will also pay a correspondingly higher rate for its input (wages and materials) and while its profits will have increased in their dollar amount, they will have diminished in their value.

As a result, the net effect has been detrimental to business profits - during the twenty-year period from 1950 to 1970, the before-tax profits of corporations little more than doubled while their debt expanded nearly fivefold. As a result, the earnings of corporations as a whole have decreased, in spite of inflation. This brings us back to the conclusion that there is no sound basis to expecting more than the average return of 8% on a portfolio of blue-chip stocks.

Stocks also suffer from fluctuation: they will not grow at a steady and uniform rate, but will advance and decline. And looking at history, they decline more rapidly than they advance. The Dow stocks took 25 years to recover the amount of value they lost in the three-year period of the 1929-1932 financial crisis.

Besides that, there is the matter of psychology: the investor whose portfolio is concentrated in stocks is "very likely to be led astray" by short-term events such as sharp losses or gains, and to react by changing out his holdings - the general tendency being to switch from a company that has lost value rather than wait for its recovery. Generally, the investment is moved from a company whose stock has recently plummeted to others that have not yet lost value, but soon will, resulting in a chain of losses that lead to financial ruin.

Alternatives to Common Stocks as Inflation Hedges

The standard practice of individuals who fear inflation, all over the world and throughout history, is to buy and hold gold. This practice was made illegal in the United States from 1935 to the time when this book was written.

(EN: Specifically, Executive Order 6102 made it illegal to own gold without a special license since May 1, 1933, though this was repealed in 1975, after the current edition of this book was published.)

As a result, the price of gold remained steady, advancing from $35 an ounce in 1935 to $48 an ounce in 1972, a rise of only 35% - not only was this less than the amount paid in savings banks, this also made it exceedingly difficult for a person to sell gold if they needed cash.

As such, the "near complete failure of gold" to protect against inflation required the investor to place his money in "things" that could be expected to maintain their value. Some of these things consisted of other commodities (there was no ban on owning silver, or any other metal), as well as in odd items such as diamonds, artwork, and collectibles.

The author finds it difficult to consider such things as collecting or hoarding to be investment activities, especially given that fluctuations in price are dramatic, unpredictable, and cannot be objectively measured or predicted, and he expects many of the readers of this book to feel the same.

Real estate has also been considered a sound long-term investment, though they are also subject to wide fluctuations and serious errors that can be made in their valuation, as well as dishonestly and opportunism that are widespread in the commercial real estate trade. The author also will not consider this as a form of investment, and strongly cautions the reader to avoid casually investing in real estate.


This returns to the practice recommended to investors in the previous chapter: to keep a portfolio primarily consisting of bonds, but using some proportion of stocks as a hedge against the prospect that inflation rates will rise in future. The precise proportion is determined by the degree to which the investor is tolerant of risk, and the degree to which he has a present need to draw upon his investments to cover the everyday expenses.