The Complex Relationship Between Inflation and Investment Performance

Key Insight

Inflation significantly impacts investments, particularly those with fixed dollar incomes or principal, which suffer from reduced purchasing power. While common stocks offer the possibility that rising dividends and share prices could offset such losses, leading many financial authorities to deem bonds undesirable and stocks inherently superior, this view is a reversal of past investment restrictions on trusts. However, it is crucial to recognize that even high-quality stocks are not always better than bonds, especially when stock market valuations are high and dividend yields are low compared to bond rates, making an 'all-stock' or 'all-bond' policy equally absurd depending on the conditions.

Historically, inflation has been a recurring phenomenon, with significant periods like 1915-1920 when the cost of living nearly doubled. Although the average annual consumer price level rise was 2.5% for 1915-1970 and 4.5% for 1965-1970, future inflation is uncertain but probable at around 3% annually. While this rate would erode about one half the income from good medium-term tax-free bonds, it would not necessarily reduce an investor's true purchasing power if they reinvested half their after-tax interest income. Despite common stocks outperforming bonds over the 55-year period (1915-1970), with the DJIA rising from an average of 77 to 753, an annual compounded rate of 4% plus 4% average dividend return, this historical performance does not guarantee similar future returns.

There is no direct, short-term correlation between inflationary conditions and common stock earnings or prices; for example, from 1966-1970, the cost of living rose 22%, but stock earnings and prices generally declined. Corporate earnings rates on capital have not generally advanced with inflation, actually falling in the past 20 years due to factors like increased depreciation and wage rates exceeding productivity gains, not inflation as a separate favorable factor. Furthermore, corporate debt expanded nearly fivefold between 1950 and 1969, while profits only doubled, making aggregate corporate debt an adverse economic factor. Consequently, investors should not expect more than an average overall return of about 8% on DJIA-type common stocks, and the market value of stocks will fluctuate, exposing buyers to risks of unsatisfactory short-term results and potentially misleading them during bull markets if their reasoning is solely tied to inflation expectations.