Inflation and the Defensive Investor

Fixed income investments fare worse during inflationary periods than do common stocks.  During inflationary periods, firms can increase prices, profits, and dividends causing their share price to increase and offsetting declines in purchasing power. 

There is no underlying connection between inflation and the movement of common stock earnings and prices.  Appreciation does not result from inflation, but rather from the re-investment of profits.  The only way for inflation to increase common stock values is to raise the rate of earnings on capital investment, which it has not done historically.

Economic prosperity usually is accompanied by slight inflation, which does not affect returns.  Offsetting factors include rising wage rates that exceed productivity gains and additional capital needs that cause interest rates to increase.  

Graham describes alternatives to common stocks as a hedge against inflation.  These alternatives range from gold and diamonds to rare paintings, stamps, and coins.  Gold has performed poorly, far worse than returns from savings in a bank account.  The latter categories, such as paying thousands of dollars for a rare coin, can not qualify as an “investment operation.”  Real Estate is still another alternative; however, its value fluctuates widely, and serious errors may be made when purchasing individual locations.  

Again, the defensive investor is best served by purchasing a portfolio of carefully chosen common stocks and bonds.

Ref:  Intelligent Investor by Benjamin Graham