Life After Full-time Work Blog

Learn about preparing for life after full-time work through posts from Don's upcoming book.

#206 Equities Are Not An Inflation Hedge

But they usually fight inflation well

 

There are many who say that equities are a great inflation hedge. To me, that’s very misleading. Yes, equities usually produce a return that’s higher than inflation. But that’s far from being a hedge. Let me explain what I mean.

First: What’s a financial hedge? Second: Who might want one? Third: Equity returns versus inflation.

***

First: What’s a financial hedge?

A hedge is an instrument that counters the adverse effects of some variable. For example, if inflation in a given year is 5%, an inflation hedge is an instrument that will counter the adverse effect that that 5% inflation will have on your finances; in other words, it will increase in value by 5%, so that the increased value will enable you to cover the 5% that inflation has added to the cost of your prior year’s spending.

***

Second: Who might want one?

Many people or firms!

All of us would want an inflation hedge – provided, of course, we don’t have to sacrifice something else in return. For example, in the example of 5% inflation, we’d all like to own an asset that increases by at least 5%, maybe more, with no chance of a return below 5%. Yeah, right! – we know we won’t find that kind of asset. What we’ll find, in practice, in exchange for the possibility of a return exceeding 5%, is the risk of a return below 5%, in which case we won’t have our spending hedged against inflation.

Similarly, if an airline is worried about the cost of fuel next year being much higher than this year’s cost, it might try to negotiate a contract that promises fuel at a specific guaranteed price next year – but that contract will have to be paid for, even if fuel prices don’t rise as much as the contract specifies.

What can those who need (or want) that precise protection do, in that case? Some simple possibilities.

One is to foresake the chance of doing even better than inflation, and buy a precise hedge. A second is to hedge partially. In other words, cover only some portion (which could be either a high or a low portion, of course) of the risk with an explicit hedge, and take the full chance of an adverse outcome on the remainder of the risk. Another is to concede the short-term hedging potential by buying an asset which, over the long term, is expected to outperform the risk (in our example, future inflation).

The corporate finance institute says:  “Traditionally, investments such as gold and real estate are preferred as a good hedge against inflation. However, some investors still prefer investing in stocks [i.e. equities] with the hope of offsetting inflation in the long term.”

Clearly, it is referring, not actually to a short-term explicit hedge, but to an investment that the owner hopes will outperform inflation over the long term.

But that’s what I’m pointing out: this is not hedging. It’s hoping to defeat inflation, in a fight. It’s not trying to match inflation in the short term (as, for example, via the interest payments in US government Treasury Inflation-Protected Securities, or TIPS, which match the US Consumer Price Index precisely). Expanding on that sports analogy, an inflation hedge would be like two riders on a tandem bike: whatever speed the first is traveling at, that’s exactly the speed at which the second one is also traveling; the legs of the riders always go round at exactly the same pace. Whereas investing in equities is like a prize fight, in which one boxer is inflation and the other boxer is gold or real estate or equities, and the hope is that, over the long term, inflation will lose the fight.

***

Third: equity returns versus inflation.

So, if we continue that fight analogy, how have equities done? I’m taking the analysis presented in Retire With Style, Episode 96, on September 19, 2023 for the numbers. (And I note the admirable accuracy of the title of that episode, which refers not to hedging inflation, but to managing inflation by using investments.)

The answer: it depends on the length of the fight (that is, the length of the time horizon for hoping to beat inflation). (And we’re looking only at US equities, in the numbers that follow.)

If it’s a one-round fight (one round meaning one year at a time), equities have won 70% of the time.

If it’s a 5-round fight (meaning, over 5-year time horizons), equities have won 77% of the time.

If it’s a 10-round fight (meaning, over 10-year time horizons), equities have won 87% of the time.

And if it’s a 15-round fight (meaning, over 15-year time horizons), equities have won 95% of the time.

So, the longer the time horizon, the more likely is has been that, in the past, (US) equities have more than matched inflation. But it has never been certain. And sometimes the equity fighter has lost a one-year fight by a huge margin: more than 30%, four times in the last hundred years, if you’re interested. If you’re really worried about inflation in the 5%-10% range, how would you like your “hedge” to place you more than 30% behind inflation?

***

So, if you’re an average retiree worried about inflation (high net worth retirees won’t need a short-term hedge, of course) in the near or even reasonably near future, you don’t have the luxury of waiting that long: you want a short-term explicit inflation hedge, rather than being willing to bet on a long-term fighter.

And that’s what I’m saying. All too often, articles and writers implicitly use the long-term-fighter analogy while using language that relates to the short-term tandem-biker situation. Don’t be misled. That’s my point.

***

Takeaway

Equities have outperformed inflation, most of the time, over long terms. That’s not the same as being an explicit short-term inflation hedge.

6 Comments


I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.


6 Responses to “#206 Equities Are Not An Inflation Hedge”

  1. David Hartley says:

    I agree. Over the long term, it is corporate earnings (paid out as dividends or reflected in the value of the shares through the application of a P/E valuation) that drive equity market returns. Companies drive and participate in economic growth so it is not surprising that, over the long term, corporate earnings grow and equities provide returns that more than offset inflation; but this does not provide a precise “hedge”. In the shorter term, fluctuations in factors such as earnings, borrowing costs and P/E multiples can more than offset long term linkages.

    From a retirement income perspective a retiree who has a 100% diversified equity portfolio, on which the dividends are sufficient to support retirement income needs, would be reasonably secure as dividends can be expected to exhibit, and have exhiibited, a tendency to rise over time. If the same person relied on harvesting capital gains to support retirement income needs, then the retiree would be less secure as there would be heavier dependency on fluctuating P/Es. To some extent, there are two different sources of capital gains for a retiree: those that emerge from an increase in the E can be harvested and spent as the underlying earnings in the retirement portfolio remain the same; while harvesting and spending the gains that emerge from an increase in the P/E will lead to a decrease in the underlying earnings in the retirement portfoio.

  2. Eric Weigel says:

    Don – the problem with hedges is that they cost money and people do no like to spend down their portfolio for this protection. Hedging is also time-consuming and complex as you constantly need to adjust the hedge ratio.

    I recently looked at currency losses to US investors with holdings in EAFE and EM equities – it’s been about a 2.7% annual loss over the last decade yet nobody wants to do any currency hedging.

    I think that hedging is beyond the skill level of most retail investors. Pre-canned solutions do not appeal because of cost, and too many people experience buyer’s regret when choosing to invest in a hedging instrument.

    • Don Ezra says:

      Right, Eric, on all counts. The cost and process of hedging went beyond the scope of what I wanted to write about. But regret in some direction is inevitable: it’s the cost that one regrets if hedging works, and the result one regrets if the hedge turned out to be necessary but wasn’t put on.

  3. Richard Bruce Austin says:

    Don, thank you for the analogies to the Tandem bicycle and the prize fighters. They were perfect pictures!

    • Don Ezra says:

      Thanks — it took a long time to come up with them! In fact I might not have written the piece if I hadn’t found them, because they vividly simplify the explanation.

Leave your question or comment