by Joseph Sheeley of The Small Investor
High inflation is challenging. Every day the prices for the goods and services you need increase, leaving you scrambling to pay for everything. You go to fill up your car and it costs $40 more. You go to the supermarket and what seems like a modest haul costs $100 or more. You go to a restaurant and need to whip out the credit card because the cash in your pocket isn’t going to cover it.
Luckily, investing in high inflation times really isn’t all that difficult. In fact, you really need to invest when inflation is high. Cash will wither and disappear with inflation. Things like stocks and real estate will grow in price with inflation. With high inflation you absolutely need to be fully invested unless you need the money soon. Otherwise, you’ll be losing purchasing power with each passing month. It’s like there is a 10% yearly tax on any money you have sitting around, so leaving $10,000 in cash will cost you $1000 per year.
Many people think of things like gold or Treasury Inflation Protected Securities (TIPS) when they think of inflation protection, but an investment in equities and other assets that have an intrinsic value works as well. It works better, in fact, because you’re investment can grow in value, rather than just keep up with inflation. Things like gold just increase in price, no value (spending power). You also don’t need to pay to store stocks, like you would with a bar of gold.
Think of it this way: A company is a machine that can create things that you can trade with others for their labor and goods that they make. If a dollar becomes worth less than it was, everyone’s costs are going up, so they need to raise their prices. Because everyone is raising their prices, the price of the goods a company produces can be increased. (Note that the value received for each item doesn’t increase. Just the price is increased.)
If the company sells items for a higher price, the profit in dollars that the company makes will increase. This means the earnings per share will increase. Because stocks normally trade within a range of price divided by earnings per share – the PE Ratio – the price of your stock will also go up if the earnings they are making, in dollar terms, is increasing.
In addition to this, the company itself has a value because if you own the company you have the ability to produce goods and make money. The equipment is in place, the employees are hired, the products are created, and the processes are defined. If you have a brand that people would pay to wear on a shirt like Coca Cola or Harley Davidson, that has value as well. These are all assets and they have an intrinsic value, so if dollars are going down in value it will take more of them to buy the company. This also makes the share price go up.
So, if you own stocks and there is inflation, the price of your shares will generally increase over time. As prices rise, so will the price of your stocks, so you’re spending power will remain the same. Being invested in stocks will therefore help protect you from inflation.
So, why are stocks going down right now?
If stock prices go up with inflation, why are they decreasing right now? The answer is that stock prices are also tied to changes in interest rates. If interest rates go up, stock prices will go down because higher interest rates can cause a slowing economy and reduced earnings in the future. And right now, the Federal Reserve is raising interest rates to try to bring inflation down, so this is causing stock prices to fall.
Also, higher inflation will eat into the returns investors get. For example, if you make 10% by investing in stocks but inflation is at 10%, you really don’t make anything. The less investors pay for a stock, the higher the potential gains they can get in the future. The markets will therefore reduce stock prices until investors think they can get a 20% return or something that is high enough to make up for the money they’re losing to inflation. With a 20% return, they’re still seeing a 10% gain in spending power once the effects of inflation are removed.
This initial decline in stock prices happens when the rate of inflation increases. Once it stabilizes at a given rate, it no longer occurs. For example, if the rate of inflation now stays at 10% per year, stocks will stop declining in price because the 10% being lost to inflation is already priced into the shares.
So why should I buy stocks now if prices are falling?
You’re probably thinking: If the Fed raises rates, stock prices will fall. They are raising rates right now, so why shouldn’t I just wait until they’re done, then buy in cheap?
The issue is that you don’t know when the Fed will stop raising rates. The best guess that the markets have right now on how far the Fed will raise is already priced into the price of stocks. If they thought rates were going to go higher, stock prices would be lower. This is called the “Efficient Market Theory.” The price of stocks always reflects all that is known at any given time.
If you were to wait on the sidelines until the Fed stated that they were done raising rates, your cash would be getting gobbled up by inflation. You’d also be missing out on dividends and other payouts from the companies. Then, when the Fed was done raising rates and the economy started to recover from what ever damage they have done, stocks would jump up in price instantly, so you’d lose a lot of the return you would have gotten if you had just bought in and waited.
While you may think that you can predict the future, you’ll make more money over time being in the market all of the time than you will if you try to time the markets. Everything you think you know about the market is already priced in there, plus a lot of things you don’t know about but others do. Trying to time the market is why most people make far lower returns than they should.
Plus, the effect of interest rates really won’t matter long-term. Rates are higher than they were a year ago (or even a few months ago), but eventually they will go back down. When they do, any losses you see now because of rising rates will be erased as stocks go up on declining rates then. Meanwhile, you’ll have seen all of the increases in stock prices from inflation plus increases due to the company becoming more productive and selling more products. Unless you need the money within a few years and can’t wait for rates to fall again, you want to be invested.
What about bonds?
Like stocks, bonds will also go down when the Fed raises rates. Just as with stocks, bond investors demand a higher return before they will commit their money when interest rates are rising and when inflation is taking away a portion of their returns. Because bonds pay a fixed amount of cash out each year, if investors can buy them at lower prices, they can receive a higher return. For example, if an Amazon 2050 bond is paying out $50 per year and the bonds cost $1000 when an investor bought them from the company, the investor would receive a 5% return each year. If the price of the bond drops to $500, the second investor who bought at the lower price would receive a 10% return. So, if you bought some Amazon bonds for $1000 each when interest rates and inflation were lower, if you tried to sell them now you might find that the best price you could get is $500 per bond or so.
Of course, unless the higher interest rates cause consumers to stop spending and Amazon goes bankrupt, in 2050 they’ll redeem then and you’ll get your $1000 per bond back. If Amazon wanted to issue some new bonds today, they’d probably need to pay out a higher interest rate like $100 per year per $1000 bond. If you bought those new bonds, the interest you would receive would partly make up for your losses to inflation.
You must be careful with bonds, however, when you’re using them to generate spending cash. For example, if you’re retired and using the money from your bonds to buy the things you need. If you spend all of the money they generate in interest each year, you’ll see your spending power go down over time. The bonds may be generating the same amount of cash, but how much that cash will buy will decrease. For example, at 10% inflation, in seven years you’ll be able to buy half as much from the interest you’re getting than you can today.
To avoid losing spending power. you either need to reinvest some of the cash generated to buy more bonds and thereby increase the amount of cash generated each year. Another option is to also be invested in stocks with a portion of the money you have. If you invest in stocks as well, the bonds would generate your spending money and you would sell off some of your stocks periodically to buy more bonds to keep up with inflation.
Wring under the pseudonym SmallIvy, Joseph Sheeley is the founder, editor, and main content writer for The Small Investor, an investing and personal finance blog focused on helping people become financially independent. He is the author of The SmallIvy Book of Investing, Book 1: Investing to Become Wealthy and FIREd by Fifty. He just released a new mini-book, Sample Mutual Fund Portfolios, which provides example portfolios for goals like investing for retirement, saving up for big expenses, and generating cash for living expenses.