Inflation Risk: The Silent Erosion
Part of our continuing series on Risk in Investing. Read the introductory article, “Risk in Investing and What to Do About It,” here.
“Inflation is the one form of taxation that can be imposed without legislation.”
— Milton Friedman
Few forces in investing are as quiet yet as destructive as inflation. It creeps through the economy like an unseen tax, steadily diminishing the purchasing power of money and the real value of savings. Even modest annual inflation of 3% halves purchasing power in roughly 24 years. For investors who view safety as holding cash or fixed income indefinitely, the cost of that comfort can be immense.
At The Prudent Speculator we have long recognized inflation not as an economic abstraction but as a constant, unrelenting headwind to wealth accumulation. Unlike market volatility, which ebbs and flows, inflation’s effect tends to be more persistent. If history is our guide, a dollar today will likely buy less tomorrow, and that arithmetic forces every investor to consider how best to protect purchasing power over time.
Understanding the Risk
Inflation risk is merely the acknowledgement of this phenomenon: that an investment’s return must be reckoned against the expected pace of rising prices over the holding period, eroding real value (net of inflation). While cash and bonds may provide nominal stability, they can be perilous in real terms. A Treasury yielding 4% offers little solace if inflation averages 3.5%. In that case, the investor earns steady interest but increases to future purchasing power are marginal.
Explore this topic further in our Comprehensive Guide to Fixed Income Investments
Of course, even equities, which have historically offered the strongest defense, are not immune. Profit margins can narrow when companies face rising costs, and valuation multiples may compress if inflation pushes interest rates higher. Yet over long periods, businesses possess something no bond has: the ability to adapt, raise prices, and potentially grow earnings in real terms.
In fact, using monthly returns data from Yale Professor Robert Shiller, we found that real (net of inflation) equity price returns were negative in only 20% of rolling 5-year periods on a monthly basis lagged behind inflation going back to 1870.1 This figure drops to 12% of periods on a rolling 10-year basis, while all rolling 20-year periods came out ahead of inflation. Of course, the odds improve considerably when including dividends and their reinvestment.
Learn more in our Comprehensive Guide to Equity Investments
Mitigating the Risk
Treasury Inflation Protected Securities (TIPS) and real estate are available vehicles investors might consider in light of the inflation dilemma. TIPS link principal to CPI and can preserve purchasing power over time, yet real yields can be negative depending on where the reset dates fall versus actual movements in the Consumer Price Index. Moreover, for TIPS owned outside tax-advantaged accounts, inflation accretion is taxable even without cash received. Real estate offers rent resets and income, with public REITs providing liquidity and transparency. It is also rate sensitive since higher cap rates and financing costs can pressure values and cash flow. Owners face maintenance capex, leasing costs and property taxes. Private vehicles add appraisal smoothing, higher fees and limited liquidity.
Many accept that gold and broad commodities offer defense against inflation, but are also not without drawbacks. Gold itself generates no cash flow and its link to inflation is inconsistent. Storage, insurance and fund fees drag on returns, while some vehicles face higher collectibles tax rates.
Indeed, every hedge has explicit and implicit costs, including the opportunity cost of replacing equities. Additionally, many who desire commodity exposure find it via investment products like ETFs, ETNs or mutual funds. These funds rarely hold barrels of oil or bushels of feedstuff. Instead, they use contracts that must be replaced every month, which impose another layer of uncertainty each time they renew. Some funds send a K-1 at tax time or have trickier taxes, have fees that are often higher than stock index funds, and ETNs are IOUs from a bank which adds a layer of credit risk.
The Prudent Speculator Perspective
Stocks remain the most accessible vehicle for wealth creation available to ordinary investors. They are imperfect, unpredictable, and at times unnerving, yet they represent ownership in the very enterprises that adapt and endure through changing price levels. We believe patience, diversification, and valuation discipline continue to offer the most sensible path to preserving and expanding real wealth over time.
While each of the various options available have a role in the investment landscape, they are not without their own trade-offs or drawbacks. So, we find several practical steps available:
- Own productive assets: Publicly traded businesses can raise prices, innovate and expand earnings in ways that preserve purchasing power.
- Diversify globally: Inflation does not strike all economies equally, and multinational exposure can cushion domestic price shocks.
- Maintain patience: Short-term changes in prices or interest rates can tempt investors to chase perceived inflation hedges, but few of those solutions come without trade-offs.
For nearly five decades The Prudent Speculator has argued that a tremendous risk investors face is not short-term price fluctuation but the long-term erosion of purchasing power. Our value-oriented approach, emphasizing companies with durable earnings, sound balance sheets, and reasonable valuations, is well suited for an inflationary world. Over appropriate time periods, we believe competitively advantaged businesses that generate consistent cash flow and return capital to shareholders through dividends and buybacks have the best chance at compounding wealth faster than inflation erodes it.
Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.
