Investing Error: Don't Use Stocks as an Inflation Hedge

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Hedge fund errorYou've heard it so often you can probably repeat it in your sleep: Equities are the best protection against inflation.

Financial planners say it. Money managers say it. Pundits and gurus say it. Without a nice chunk of equities in our portfolio, we are told, inflation will ravage our net worth, and we may not have anything left for our very old age.

That's why some experts have even recommended that retirees or near-retirees hold 60% or more of their assets in stocks -- terrible advice, and it destroyed many people's finances and peace of mind during the crash a couple of years ago.

The market has come back since then -- without the participation of those who sold at the bottom in despair -- so maybe some advisors believe it was sound thinking after all.

But academic research, old and new, completely flies in the face of this conventional "wisdom." It establishes clearly that stocks are not a very good hedge at all against inflation, particularly high inflation. Even Stocks for the Long Run himself, Jeremy Siegel, acknowledges that.

"Historically, that's been the case," said John Tatom, a finance professor at Indiana State University." I claim that's one of the most well-established tenets in financial economics."


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In a 2011 paper, Tatom wrote: "There is a strong negative correlation between inflation and real and nominal stock prices. Contrary to opinion, equities are not a good hedge against inflation."

Some new research by three noted experts on asset prices confirms this. Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School have one of the world's deepest databases on the performance of stocks, bonds, bills, and currencies, as well as inflation. It covers 19 different markets and goes all the way back to 1900.

In an article in the 2012 Credit Suisse Global Investment Returns Yearbook, they found that during periods of "marked" inflation, equities easily outperform bonds, probably the worst investment to own during inflationary episodes. Yet equities gave a real return of -12% during those periods, while bonds lost 23.2%. Double ouch.

"When inflation has been moderate and stable,...equities have performed relatively well," the three professors concluded. "When there has been a leap in inflation, equities have performed less well in real terms. These sharp jumps in inflation are dangerous for investors."

"High inflation reduces equity values," they summed up.


Confusing ROI with Inflation Protection


So why have so many experts embraced equities as an inflation hedge? Because they're confusing the large total returns investors may have earned from equities over long periods of time with an actual "hedge" against inflation.

Because of their greater risk, equities tend to produce bigger rewards over the long run -- say, 20 years or more.

But that's not quite in the bag, either.

Exhibit A: the lost decade. The average annual total return for the S&P 500 index from 1999 to 2011 was -0.4%. So, we're going to need a hell of a good next eight years to reach the S&P's long-term averages of just under 10% a year in this 20-year period. Dow 36,000 anyone?

Of course, if you invested in certain types of stocks -- small-cap value, real estate investment trusts, and emerging markets -- you would have done well. But who knew that in 1999?

And when it comes to inflation, even the esteemed Jeremy Siegel of The Wharton School of the University of Pennsylvania hedges his bets, so to speak.

"Over 30-year periods, the return on stocks after inflation is virtually unaffected by the inflation rate," he wrote in Kiplinger's last year. "Although stocks do well when annual inflation is in the range of 2% to 5%, their performance begins to falter when inflation exceeds 5%."

Why? Because "companies can't always pass along increased costs, especially in the case of an important raw material, such as oil. As a result, many companies will see their profits squeezed," he wrote.

Siegel's conclusion: "Stocks are not good short-term hedges against rapidly increasing inflation, but bonds are worse."

What You Should Actually Buy


So, what does that mean? If you own a lot of stock because you want to protect your portfolio against inflation, you probably should sell some.

For instance, if you're five to ten years from retirement and you have 50% to 60% of your assets in stocks, you should reduce those holdings to 40 to 50% of your portfolio.

And if you're worried about inflation, you should take some of that money -- and sell some of your bond holdings, too-- to buy some asset classes that have better track records as inflation hedges.


Such as? "In periods of high and increasing inflation, gold and commodities are definitely something you want in your portfolio," said Mark Johannessen, managing director of Harris SBSB in McLean, Va., and former president of the Financial Planning Association.

Dimson, Marsh, and Staunton's research backs him up. "Gold is the only asset that does not have its real value reduced by inflation," they write. "Gold has on average been resistant to the impact of inflation. However, investment in gold has generated volatile price fluctuations...There have been long periods when the gold investor was 'underwater' in real terms."

Not for the last decade, of course, when gold rose more than sevenfold before stalling below $1,900 per ounce. But the researchers are talking about the very long run.

Another good hedge: housing. Don't everyone all groan at once. According to Dimson, Marsh, and Staunton, "real house-price changes ... seem relatively insensitive to inflation ... Housing has provided a long-term capital appreciation that is similar in magnitude to gold."

Unfortunately, U.S. housing has produced the weakest returns of major markets over the last century, so if you'd like to hedge against inflation with your home, pack up and move to Australia.

Real estate investment trusts (REITs) may be a decent substitute, but there aren't as much data on their performance over many, many years -- and they've had a big run.

Finally, there are TIPs (Treasury inflation-protected securities), inflation-linked bonds issued by the US and other governments. Smart people like David Swensen, Yale's chief investment officer, recommend them for individual investors as good protection against inflation. But they're very expensive now.

So, what should you do? I'd take some profits in your stock and bond holdings and buy small positions (maybe 5% of your portfolio each) in gold, commodities, REITs, and TIPs ETFs, preferably when they've sold off a bit, too.

Then, I'd keep 40% to 50% in stock, 20% to 30% in bonds, and another 10% in cash. That way, you'll have some protection against inflation, deflation, and just normal life.

And if your financial advisor tells you to buy more stock to keep from outliving your money, tell him or her that in the long run, we're all dead.



Howard R. Gold is editor at large for MoneyShow.com and columnist for MarketWatch. You can follow him on Twitter @howardrgold and read why
Republicans need to stop pining for a white knight at The Independent.

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