The Investor and Inflation

The Investor and Inflation

 Inflation, and the fight against it, has been very much in the
 public’s mind in recent years. The shrinkage in the purchasing
 power of the dollar in the past, and particularly the fear (or hope
 by speculators) of a serious further decline in the future, has
 greatly influenced the thinking of Wall Street. It is clear that those
 with a fixed dollar income will suffer when the cost of living
 advances, and the same applies to a fixed amount of dollar princi
 pal. Holders of stocks, on the other hand, have the possibility that a
 loss of the dollar’s purchasing power may be offset by advances in
 their dividends and the prices of their shares.
    On the basis of these undeniable facts many financial authorities
 have concluded that (1) bonds are an inherently undesirable form
 of investment, and (2) consequently, common stocks are by their
 very nature more desirable investments than bonds. We have
 heard of charitable institutions being advised that their portfolios
 should consist 100% of stocks and zero percent of bonds.* This is
 quite a reversal from the earlier days when trust investments were

 * By the late 1990s, this advice—which can be appropriate for a foundation 
 or endowment with an infinitely long investment horizon—had spread to indi-
 vidual investors, whose life spans are finite. In the 1994 edition of his influ-
 ential book, Stocks for the Long Run, finance professor Jeremy Siegel of the
 Wharton School recommended that “risk-taking” investors should buy on
 margin, borrowing more than a third of their net worth to sink 135% of their
 assets into stocks. Even government officials got in on the act: In February
 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the
 audience at an investment conference: “It doesn’t make any sense for any-
 one to have any money in a bond fund.”

The Investor and Inflation 48
 restricted by law to high-grade bonds (and a few choice preferred
    Our readers must have enough intelligence to recognize that
 even high-quality stocks cannot be a better purchase than bonds
 under all conditions—i.e., regardless of how high the stock market
 may be and how low the current dividend return compared with
 the rates available on bonds. A statement of this kind would be as
 absurd as was the contrary one—too often heard years ago—that
 any bond is safer than any stock. In this chapter we shall try to
 apply various measurements to the inflation factor, in order to
 reach some conclusions as to the extent to which the investor may
 wisely be influenced by expectations regarding future rises in the
 price level.
      In this matter, as in so many others in finance, we must base our
 views of future policy on a knowledge of past experience. Is infla-
 tion something new for this country, at least in the serious form it
 has taken since 1965? If we have seen comparable (or worse) infla-
 tions in living experience, what lessons can be learned from them
 in confronting the inflation of today? Let us start with Table 2-1, a
 condensed historical tabulation that contains much information
 about changes in the general price level and concomitant changes
 in the earnings and market value of common stocks. Our figures
 will begin with 1915, and thus cover 55 years, presented at five-
 year intervals. (We use 1946 instead of 1945 to avoid the last year of
 wartime price controls.)
      The first thing we notice is that we have had inflation in the
 past—lots of it. The largest five-year dose was between 1915 and
 1920, when the cost of living nearly doubled. This compares with
 the advance of 15% between 1965 and 1970. In between, we have
 had three periods of declining prices and then six of advances at
 varying rates, some rather small. On this showing, the investor
 should clearly allow for the probability of continuing or recurrent
 inflation to come.
      Can we tell what the rate of inflation is likely to be? No clear
 answer is suggested by our table; it shows variations of all sorts. It
 would seem sensible, however, to take our cue from the rather con-
 sistent record of the past 20 years. The average annual rise in the
 consumer price level for this period has been 2.5%; that for
 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-

The Investor and Inflation 50
 ment policy has been strongly against large-scale inflation, and
 there are some reasons to believe that Federal policies will be more
 effective in the future than in recent years.* We think it would be
 reasonable for an investor at this point to base his thinking and
 decisions on a probable (far from certain) rate of future inflation of,
 say, 3% per annum. (This would compare with an annual rate of
 about 21 ⁄2% for the entire period 1915–1970.)1
      What would be the implications of such an advance? It would
 eat up, in higher living costs, about one-half the income now
 obtainable on good medium-term tax-free bonds (or our assumed
 after-tax equivalent from high-grade corporate bonds). This would
 be a serious shrinkage, but it should not be exaggerated. It would
 not mean that the true value, or the purchasing power, of the
 investor’s fortune need be reduced over the years. If he spent half
 his interest income after taxes he would maintain this buying
 power intact, even against a 3% annual inflation.
      But the next question, naturally, is, “Can the investor be reason-
 ably sure of doing better by buying and holding other things than
 high-grade bonds, even at the unprecedented rate of return offered
 in 1970–1971?” Would not, for example, an all-stock program be
 preferable to a part-bond, part-stock program? Do not common
 stocks have a built-in protection against inflation, and are they not
 almost certain to give a better return over the years than will
 bonds? Have not in fact stocks treated the investor far better than
 have bonds over the 55-year period of our study?
       The answer to these questions is somewhat complicated. Com-
 mon stocks have indeed done better than bonds over a long period
 of time in the past. The rise of the DJIA from an average of 77 in
 1915 to an average of 753 in 1970 works out at an annual com-
 pounded rate of just about 4%, to which we may add another 4%
 for average dividend return. (The corresponding figures for the
 S & P composite are about the same.) These combined figures of 8%

  * This is one of Graham’s rare misjudgments. In 1973, just two years after 
President Richard Nixon imposed wage and price controls, inflation hit 
8.7%, its highest level since the end of World War II. The decade from 1973
 through 1982 was the most inflationary in modern American history, as the
 cost of living more than doubled. 

The Investor and Inflation 51
per year are of course much better than the return enjoyed from
bonds over the same 55-year period. But they do not exceed that
now offered by high-grade bonds. This brings us to the next logical
question: Is there a persuasive reason to believe that common
stocks are likely to do much better in future years than they have in
the last five and one-half decades?
      Our answer to this crucial question must be a flat no. Common
 stocks may do better in the future than in the past, but they are far
 from certain to do so. We must deal here with two different time
 elements in investment results. The first covers what is likely to
 occur over the long-term future—say, the next 25 years. The second
 applies to what is likely to happen to the investor—both financially
 and psychologically—over short or intermediate periods, say five
 years or less. His frame of mind, his hopes and apprehensions, his
 satisfaction or discontent with what he has done, above all his deci-
 sions what to do next, are all determined not in the retrospect of
 a lifetime of investment but rather by his experience from year
 to year.
       On this point we can be categorical. There is no close time con-
 nection between inflationary (or deflationary) conditions and the
 movement of common-stock earnings and prices. The obvious
 example is the recent period, 1966–1970. The rise in the cost of liv-
 ing was 22%, the largest in a five-year period since 1946–1950. But
 both stock earnings and stock prices as a whole have declined since
 1965. There are similar contradictions in both directions in the
 record of previous five-year periods.
 Inflation and Corporate Earnings
       Another and highly important approach to the subject is by a
 study of the earnings rate on capital shown by American business.
 This has fluctuated, of course, with the general rate of economic
 activity, but it has shown no general tendency to advance with
 wholesale prices or the cost of living. Actually this rate has fallen
 rather markedly in the past twenty years in spite of the inflation of
 the period. (To some degree the decline was due to the charging of
 more liberal depreciation rates. See Table 2-2.) Our extended studies
 have led to the conclusion that the investor cannot count on much
 above the recent five-year rate earned on the DJIA group—

The Investor and Inflation 52
 about 10% on net tangible assets (book value) behind the shares.2
 Since the market value of these issues is well above their book
 value—say, 900 market vs. 560 book in mid-1971—the earnings on
 current market price work out only at some 61 ⁄4%. (This relation-
 ship is generally expressed in the reverse, or “times earnings,”
 manner—e.g., that the DJIA price of 900 equals 18 times the actual
 earnings for the 12 months ended June 1971.)
       Our figures gear in directly with the suggestion in the previous
 chapter* that the investor may assume an average dividend return
 of about 3.5% on the market value of his stocks, plus an appreciation
 of, say, 4% annually resulting from reinvested profits. (Note that
 each dollar added to book value is here assumed to increase the
 market price by about $1.60.)
       The reader will object that in the end our calculations make no
 allowance for an increase in common-stock earnings and values to
 result from our projected 3% annual inflation. Our justification is
 the absence of any sign that the inflation of a comparable amount
 in the past has had any direct effect on reported per-share earnings.
 The cold figures demonstrate that all the large gain in the earnings
 of the DJIA unit in the past 20 years was due to a proportionately
 large growth of invested capital coming from reinvested profits. If
 inflation had operated as a separate favorable factor, its effect
 would have been to increase the “value” of previously existing
 capital; this in turn should increase the rate of earnings on such old
 capital and therefore on the old and new capital combined. But
 nothing of the kind actually happened in the past 20 years, during
 which the wholesale price level has advanced nearly 40%. (Business
 earnings should be influenced more by wholesale prices than by
 “consumer prices.”) The only way that inflation can add to common
 stock values is by raising the rate of earnings on capital investment.
 On the basis of the past record this has not been the case.
        In the economic cycles of the past, good business was accompa-
 nied by a rising price level and poor business by falling prices. It
 was generally felt that “a little inflation” was helpful to business
 profits. This view is not contradicted by the history of 1950–1970,

 * See p. 25.

The Investor and Inflation 52
 which reveals a combination of generally continued prosperity and
 generally rising prices. But the figures indicate that the effect of all
 this on the earning power of common-stock capital (“equity capital”)
 has been quite limited; in fact it has not even served to maintain the
 rate of earnings on the investment. Clearly there have been important
 offsetting influences which have prevented any increase in the real
 profitability of American corporations as a whole. Perhaps the most
 important of these have been (1) a rise in wage rates exceeding the
 gains in productivity, and (2) the need for huge amounts of new capital,
 thus holding down the ratio of sales to capital employed.
    Our figures in Table 2-2 indicate that so far from inflation having
 benefited our corporations and their shareholders, its effect has
 been quite the opposite. The most striking figures in our table are
 those for the growth of corporate debt between 1950 and 1969. It is
 surprising how little attention has been paid by economists and by
 Wall Street to this development. The debt of corporations has
 expanded nearly fivefold while their profits before taxes a little
 more than doubled. With the great rise in interest rates during this
 period, it is evident that the aggregate corporate debt is now an
The Investor and Inflation 54
 adverse economic factor of some magnitude and a real problem for
 many individual enterprises. (Note that in 1950 net earnings after
 interest but before income tax were about 30% of corporate debt,
 while in 1969 they were only 13.2% of debt. The 1970 ratio must
 have been even less satisfactory.) In sum it appears that a signifi-
 cant part of the 11% being earned on corporate equities as a whole
 is accomplished by the use of a large amount of new debt costing
 4% or less after tax credit. If our corporations had maintained the
 debt ratio of 1950, their earnings rate on stock capital would have
 fallen still lower, in spite of the inflation.
       The stock market has considered that the public-utility enter-
 prises have been a chief victim of inflation, being caught between a
 great advance in the cost of borrowed money and the difficulty of
 raising the rates charged under the regulatory process. But this
 may be the place to remark that the very fact that the unit costs of
 electricity, gas, and telephone services have advanced so much less
 than the general price index puts these companies in a strong
 strategic position for the future.3 They are entitled by law to charge
 rates sufficient for an adequate return on their invested capital, and
 this will probably protect their shareholders in the future as it has
 in the inflations of the past.
       All of the above brings us back to our conclusion that the
 investor has no sound basis for expecting more than an average
 overall return of, say, 8% on a portfolio of DJIA-type common
 stocks purchased at the late 1971 price level. But even if these
 expectations should prove to be understated by a substantial
 amount, the case would not be made for an all-stock investment
 program. If there is one thing guaranteed for the future, it is that
 the earnings and average annual market value of a stock portfolio
 will not grow at the uniform rate of 4%, or any other figure. In the
 memorable words of the elder J. P. Morgan, “They will fluctuate.”*
 This means, first, that the common-stock buyer at today’s prices—

 * John Pierpont Morgan was the most powerful financier of the late nine-
 teenth and early twentieth centuries. Because of his vast influence, he was
 constantly asked what the stock market would do next. Morgan developed a 
 mercifully short and unfailingly accurate answer: “It will fluctuate.” See Jean
 Strouse, Morgan: American Financier (Random House, 1999), p. 11.

The Investor and Inflation 55
 or tomorrow’s—will be running a real risk of having unsatisfactory
 results therefrom over a period of years. It took 25 years for General
 Electric (and the DJIA itself) to recover the ground lost in the
 1929–1932 debacle. Besides that, if the investor concentrates his
 portfolio on common stocks he is very likely to be led astray either
 by exhilarating advances or by distressing declines. This is particu-
 larly true if his reasoning is geared closely to expectations of further
 inflation. For then, if another bull market comes along, he will take
 the big rise not as a danger signal of an inevitable fall, not as a
 chance to cash in on his handsome profits, but rather as a vindica-
 tion of the inflation hypothesis and as a reason to keep on buying
 common stocks no matter how high the market level nor how low
 the dividend return. That way lies sorrow.

Alternatives to Common Stocks as Inflation Hedges
       The standard policy of people all over the world who mistrust
 their currency has been to buy and hold gold. This has been against
 the law for American citizens since 1935—luckily for them. In the
 past 35 years the price of gold in the open market has advanced
 from $35 per ounce to $48 in early 1972—a rise of only 35%. But
 during all this time the holder of gold has received no income
 return on his capital, and instead has incurred some annual expense
 for storage. Obviously, he would have done much better with his
 money at interest in a savings bank, in spite of the rise in the
 general price level.
      The near-complete failure of gold to protect against a loss in the
 purchasing power of the dollar must cast grave doubt on the ability
 of the ordinary investor to protect himself against inflation by
 putting his money in “things.”* Quite a few categories of valuable

 * The investment philosopher Peter L. Bernstein feels that Graham was
  “dead wrong” about precious metals, particularly gold, which (at least in 
   the years after Graham wrote this chapter) has shown a robust ability to out-
   pace inflation. Financial adviser William Bernstein agrees, pointing out that
   a tiny allocation to a precious-metals fund (say, 2% of your total assets) is 
   too small to hurt your overall returns when gold does poorly. But, when gold
   does well, its returns are often so spectacular—sometimes exceeding 100% 

The Investor and Inflation 56
 objects have had striking advances in market value over the
 years—such as diamonds, paintings by masters, first editions of
 books, rare stamps and coins, etc. But in many, perhaps most, of
 these cases there seems to be an element of the artificial or the
 precarious or even the unreal about the quoted prices. Somehow
 it is hard to think of paying $67,500 for a U.S. silver dollar dated
 1804 (but not even minted that year) as an “investment operation.”4
 We acknowledge we are out of our depth in this area. Very few of
 our readers will find the swimming safe and easy there.
      The outright ownership of real estate has long been considered
 as a sound long-term investment, carrying with it a goodly amount
 of protection against inflation. Unfortunately, real-estate values are
 also subject to wide fluctuations; serious errors can be made in
 location, price paid, etc.; there are pitfalls in salesmen’s wiles.
 Finally, diversification is not practical for the investor of moderate
 means, except by various types of participations with others and
 with the special hazards that attach to new flotations—not too dif-
 ferent from common-stock ownership. This too is not our field. All
 we should say to the investor is, “Be sure it’s yours before you go
 into it.”

      Naturally, we return to the policy recommended in our previous
 chapter. Just because of the uncertainties of the future the investor
 cannot afford to put all his funds into one basket—neither in the
 bond basket, despite the unprecedentedly high returns that bonds
 have recently offered; nor in the stock basket, despite the prospect
 of continuing inflation.
      The more the investor depends on his portfolio and the income
 therefrom, the more necessary it is for him to guard against the

 in a year—that it can, all by itself, set an otherwise lackluster portfolio glitter-
ing. However, the intelligent investor avoids investing in gold directly, with its
high storage and insurance costs; instead, seek out a well-diversified mutual
 fund specializing in the stocks of precious-metal companies and charging 
below 1% in annual expenses. Limit your stake to 2% of your total financial 
assets (or perhaps 5% if you are over the age of 65). 

The Investor and Inflation 57
unexpected and the disconcerting in this part of his life. It is
axiomatic that the conservative investor should seek to minimize
his risks. We think strongly that the risks involved in buying, say,
a telephone-company bond at yields of nearly 71 ⁄2% are much less
than those involved in buying the DJIA at 900 (or any stock list
equivalent thereto). But the possibility of large-scale inflation
remains, and the investor must carry some insurance against it.
There is no certainty that a stock component will insure adequ-
ately against such inflation, but it should carry more protection
than the bond component.
     This is what we said on the subject in our 1965 edition (p. 97),
and we would write the same today:
      It must be evident to the reader that we have no enthusiasm for
common stocks at these levels (892 for the DJIA). For reasons
already given we feel that the defensive investor cannot afford to
be without an appreciable proportion of common stocks in his
portfolio, even if we regard them as the lesser of two evils—the
greater being the risks in an all-bond holding.


     Americans are getting stronger. Twenty years ago, it took two
     people to carry ten dollars’ worth of groceries. Today, a five-
     year-old can do it.
                                              —Henny Youngman

 Inflation? Who cares about that?
       After all, the annual rise in the cost of goods and services averaged
 less than 2.2% between 1997 and 2002—and economists believe that
 even that rock-bottom rate may be overstated.1 (Think, for instance,
 of how the prices of computers and home electronics have plummeted—
 and how the quality of many goods has risen, meaning that consumers
 are getting better value for their money.) In recent years, the true rate
 of inflation in the United States has probably run around 1% annually—
 an increase so infinitesimal that many pundits have proclaimed
 that “inflation is dead.”

1 The U.S. Bureau of Labor Statistics, which calculates the Consumer Price
 Index that measures inflation, maintains a comprehensive and helpful web-
site at
2 For a lively discussion of the “inflation is dead” scenario, see www.pbs. org/newshour/bb/economy/july-dec97/inflation_12-16.html. In 1996, the
 Boskin Commission, a group of economists asked by the government to
 investigate whether the official rate of inflation is accurate, estimated that
 it has been overstated, often by nearly two percentage points per year. For
 the commission’s report, see
 Many investment experts now feel that deflation, or falling prices, is an
 even greater threat than inflation; the best way to hedge against that risk
 is by including bonds as a permanent component of your portfolio. 
(See the commentary on Chapter 4.) 

 Commentary on Chapter 2- 59


There’s another reason investors overlook the importance of inflation: 
 what psychologists call the “money illusion.” If you receive a 2% raise
 in a year when inflation runs at 4%, you will almost certainly feel better 
 than you will if you take a 2% pay cut during a year when inflation is
 zero. Yet both changes in your salary leave you in a virtually identical
 position—2% worse off after inflation. So long as the nominal (or
 absolute) change is positive, we view it as a good thing—even if the
 real (or after-inflation) result is negative. And any change in your own
 salary is more vivid and specific than the generalized change of prices
 in the economy as a whole.3 Likewise, investors were delighted to earn
 11% on bank certificates of deposit (CDs) in 1980 and are bitterly dis-
 appointed to be earning only around 2% in 2003—even though they
 were losing money after inflation back then but are keeping up with
 inflation now. The nominal rate we earn is printed in the bank’s ads 
 and posted in its window, where a high number makes us feel good.
 But inflation eats away at that high number in secret. Instead of 
 taking out ads, inflation just takes away our wealth. That’s why inflation
 is so easy to overlook—and why it’s so important to measure your
 investing success not just by what you make, but by how much you
 keep after inflation.
       More basically still, the intelligent investor must always be on guard
 against whatever is unexpected and underestimated. There are three 
 good reasons to believe that inflation is not dead:

 •  As recently as 1973–1982, the United States went through one
    of the most painful bursts of inflation in our history. As measured
    by the Consumer Price Index, prices more than doubled over that
    period, rising at an annualized rate of nearly 9%. In 1979 alone,
    inflation raged at 13.3%, paralyzing the economy in what became
    known as “stagflation”—and leading many commentators to 
    question whether America could compete in the global market-

 3 For more insights into this behavioral pitfall, see Eldar Shafir, Peter Dia-
 mond, and Amos Tversky, “Money Illusion,” in Daniel Kahneman and Amos
 Tversky, eds., Choices, Values, and Frames (Cambridge University Press,
 2000), pp. 335–355. 

Commentary on Chapter 2- 60
    place.4 Goods and services priced at $100 in the beginning of 
    1973 cost $230 by the end of 1982, shriveling the value of a dol-
    lar to less than 45 cents. No one who lived through it would scoff
    at such destruction of wealth; no one who is prudent can fail to
    protect against the risk that it might recur.
 •  Since 1960, 69% of the world’s market-oriented countries have
    suffered at least one year in which inflation ran at an annualized
    rate of 25% or more. On average, those inflationary periods
    destroyed 53% of an investor’s purchasing power.5 We would be 
    crazy not to hope that America is somehow exempt from such a 
    disaster. But we would be even crazier to conclude that it can
    never happen here.6
 •  Rising prices allow Uncle Sam to pay off his debts with dollars
    that have been cheapened by inflation. Completely eradicating 
    inflation runs against the economic self-interest of any govern-
    ment that regularly borrows money.7

4 That year, President Jimmy Carter gave his famous “malaise” speech, in
 which he warned of “a crisis in confidence” that “strikes at the very heart
and soul and spirit of our national will” and “threatens to destroy the social 
and the political fabric of America.”
5 See Stanley Fischer, Ratna Sahay, and Carlos A. Vegh, “Modern Hyper-
and High Inflations,” National Bureau of Economic Research, Working 
Paper 8930, at
6 In fact, the United States has had two periods of hyperinflation. During the 
 American Revolution, prices roughly tripled every year from 1777 through
 1779, with a pound of butter costing $12 and a barrel of flour fetching 
 nearly $1,600 in Revolutionary Massachusetts. During the Civil War, infla-
 tion raged at annual rates of 29% (in the North) and nearly 200% (in the
 Confederacy). As recently as 1946, inflation hit 18.1% in the United States.
 7 I am indebted to Laurence Siegel of the Ford Foundation for this cynical,
 but accurate, insight. Conversely, in a time of deflation (or steadily falling
 prices) it’s more advantageous to be a lender than a borrower—which is why
 most investors should keep at least a small portion of their assets in bonds,
 as a form of insurance against deflating prices.

Commentary on Chapter 2- 61


What, then, can the intelligent investor do to guard against inflation? 
The standard answer is “buy stocks”—but, as common answers so 
often are, it is not entirely true. 
     Figure 2-1 shows, for each year from 1926 through 2002, the rela-
tionship between inflation and stock prices.
     As you can see, in years when the prices of consumer goods and 
services fell, as on the left side of the graph, stock returns were terri-
ble—with the market losing up to 43% of its value.8 When inflation 
shot above 6%, as in the years on the right end of the graph, stocks
also stank. The stock market lost money in eight of the 14 years in
which inflation exceeded 6%; the average return for those 14 years
was a measly 2.6%. 
     While mild inflation allows companies to pass the increased costs
 of their own raw materials on to customers, high inflation wreaks 
 havoc—forcing customers to slash their purchases and depressing
 activity throughout the economy.
     The historical evidence is clear: Since the advent of accurate 
stock-market data in 1926, there have been 64 five-year periods 
(i.e., 1926–1930, 1927–1931, 1928–1932, and so on through 
1998–2002). In 50 of those 64 five-year periods (or 78% of the
time), stocks outpaced inflation.9 That’s impressive, but imper-
fect; it means that stocks failed to keep up with inflation about
one-fifth of the time.

 8 When inflation is negative, it is technically termed “deflation.” Regularly 
falling prices may at first sound appealing, until you think of the Japanese
 example. Prices have been deflating in Japan since 1989, with real estate
 and the stock market dropping in value year after year—a relentless water
 torture for the world’s second-largest economy.
9 Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2003 Handbook
 (Ibbotson Associates, Chicago, 2003), Table 2-8. The same pattern is evi-
dent outside the United States: In Belgium, Italy, and Germany, where infla-
tion was especially high in the twentieth century, “inflation appears to have
 had a negative impact on both stock and bond markets,” note Elroy Dimson,
 Paul Marsh, and Mike Staunton in Triumph of the Optimists: 101 Years of 
Global Investment Returns (Princeton University Press, 2002), p. 53.

Commentary on Chapter 2- 63


 Fortunately, you can bolster your defenses against inflation by branch-
 ing out beyond stocks. Since Graham last wrote, two inflation-fighters
 have become widely available to investors: 
     REITs. Real Estate Investment Trusts, or REITs (pronounced
 “reets”), are companies that own and collect rent from commercial
 and residential properties.10 Bundled into real-estate mutual funds, 
 REITs do a decent job of combating inflation. The best choice is
 Vanguard REIT Index Fund; other relatively low-cost choices include
 Cohen & Steers Realty Shares, Columbia Real Estate Equity Fund, 
 and Fidelity Real Estate Investment Fund.11 While a REIT fund is
 unlikely to be a foolproof inflation-fighter, in the long run it should
 give you some defense against the erosion of purchasing power 
 without hampering your overall returns. 
    TIPS. Treasury Inflation-Protected Securities, or TIPS, are U.S. 
 government bonds, first issued in 1997, that automatically go up in
 value when inflation rises. Because the full faith and credit of the 
 United States stands behind them, all Treasury bonds are safe from
 the risk of default (or nonpayment of interest). But TIPS also guaran-
 tee that the value of your investment won’t be eroded by inflation. In
 one easy package, you insure yourself against financial loss and the
 loss of purchasing power.12
    There is one catch, however. When the value of your TIPS bond
 rises as inflation heats up, the Internal Revenue Service regards that
 increase in value as taxable income—even though it is purely a paper 

10 Thorough, if sometimes outdated, information on REITs can be found at 
11 For further information, see, www.cohenandsteers.
 com,, and The case for investing 
in a REIT fund is weaker if you own a home, since that gives you an inherent
 stake in real-estate ownership.
12 A good introduction to TIPS can be found at 
of/ofinflin.htm. For more advanced discussions, see www.federalreserve. gov/Pubs/feds/2002/200232/200232pap.pdf, 
Publications/resdiags/73_09-2002.htm, and 

Commentary on Chapter 2- 64
 gain (unless you sold the bond at its newly higher price). Why does
 this make sense to the IRS? The intelligent investor will remember the
 wise words of financial analyst Mark Schweber: “The one question
 never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax
 complication, TIPS are best suited for a tax-deferred retirement 
 account like an IRA, Keogh, or 401(k), where they will not jack up
 your taxable income.
     You can buy TIPS directly from the U.S. government at www., or in a low-cost mutual fund like 
 Vanguard Inflation-Protected Securities or Fidelity Inflation-Protected
 Bond Fund.13 Either directly or through a fund, TIPS are the ideal sub-
 stitute for the proportion of your retirement funds you would otherwise
 keep in cash. Do not trade them: TIPS can be volatile in the short run,
 so they work best as a permanent, lifelong holding. For most investors,
 allocating at least 10% of your retirement assets to TIPS is an intelli-
 gent way to keep a portion of your money absolutely safe—and entirely
 beyond the reach of the long, invisible claws of inflation.

 13 For details on these funds, see or

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