Reader Michael wrote in and asked:
At the beginning of inflation/rate hike cycle, everything I read said invest in stocks and real estate (and TIPS) to beat inflation. It sure doesn’t feel like stocks beat inflation but I haven’t run the numbers… Can you show how accurate these suggestions were and what, if anything, did beat inflation the past 2 or 3 years?
Michael
What a fantastic question. Let’s answer it today. We’ll need to take a few baby steps to answer Michael’s question.
- What time frame are we going to look at (and why)?
- What asset classes are we going to look at (and why)?
- What tools can we use to look at those asset classes and compare their performance?
What’s Our Timeframe?
We must start by determining a “before” and “after.” Are we looking at inflation? Or the Fed’s interest rate hikes? A combination of both?
The current jumble of inflation and interest rates is undoubtedly connected to COVID-19. The Federal Reserve swiftly lowered interest rates in response to the pandemic’s economic slowdown and printed a few trillion dollars.
To answer today’s question, we should start prior to that period. January 2020 makes sense. For an end date, we’ll pick right now – December 2023. Here’s how interest rates (in orange) and inflation (purple) have changed over time. For ease of comparison, the inflation line shows a total increase of 19.03% in the past 36 months.
What Asset Classes Are We Looking At (And Why)?
Specifically, Michael asked about stocks, real estate, and TIPS** in his question.
TIPS are Treasury Inflation-Protected Bonds. These bonds provide a small nominal return plus a variable return based on rates of inflation. They are, as the name implies “inflation-protected” and, in theory, should not have been negatively affected by recent inflation.
We must also look at the most basic, inflation-exposed asset: cash. I also want to look at traditional bonds and commodities.
Most bonds aren’t TIPS. They’re not inflation-protected. In fact, inflation is a bond investor’s worst nightmare. The cashflow from a bond is guaranteed to be fixed. Inflation guarantees the value of those fixed dollars slowly decays. Not good.
Commodities – like oil, gold, timber, pork, etc. – should, in theory, rise with inflation. As prices rise around us, the price of commodities should rise too. While the magnitude of commodity inflation might not match CPI data 1-to-1, we *should* see some correlation.
The Results
Remember: our inflation figure is 19.03% over this time period. In comparison, our six asset classes have performed:
- Cash = +6.33% (in purple below)
- Stocks = +49.32% (orange)
- Real estate = +3.59% (blue)
- TIPS = +11.17% (green)
- Bonds = (-5.27%) (pink)
- Commodities = +42.36% (brown)
Back to Michael’s original question:
- Stocks provided a legitimate real return (despite 2022 being a bad year). Take it with a grain of salt, though. I’m not a proponent of using a 3-year stock market return to prove an investing idea – stocks are just too volatile. Today’s article is a special case based on the inflation/interest rate timeline we chose.
- Real estate got crushed. Some of you might be thinking, “Aren’t houses and apartments crazy expensive?! How can real estate be doing poorly?” For today’s purposes, we’re using Vanguard’s most diversified real estate index fund as our measuring stick. That fund includes various commercial real estate sectors, many of which got 1) crushed by COVID and then 2) got similarly throttled by the interest rate hikes of 2022. It’s been a tough period for real estate investors.
- TIPS “only” returned 11.17%, despite the promise they’d keep up with inflation. What gives?! The main explanation is, once again, rising interest rates. TIPS should be thought of as two-products-in-one. The first product is a normal bond with a fixed nominal return. The second is a variable aspect that protects against unexpected inflation. While the second portion is doing its job, the first “normal bond” portion has been negatively affected by rising interest rates just like all other bonds (in pink). TIPS are doing what they’re meant to do…but that doesn’t mean TIPS investors are excited about it. In fact, if you compare TIPS (+11.17%) to normal bonds (-5.27%) the difference is pretty close to the overall rate of inflation, which is what we’d expect.
- Commodities are up 42.36% – wow! But when I see that commodities plot, I see volatility! Plus, commodities are not income-producing assets. That’s the main reason I don’t own commodities, and not even today’s graph is going to change my mind.
- Finally, we have cash providing a slow, steady 6.33% return. The lesson is clear: cash loses ground to inflation. Period. Cash is vital to meet your near-term financial needs. That cash should be parked somewhere earning ~5% right now. But that’s not a long-term solution, nor a reason to be overexposed to cash right now. Long-term assets need to be elsewhere, earning a real return above inflation.
Michael, thanks for the awesome question. Hopefully these lessons help us out some time in the future.
Thank you for reading! If you enjoyed this article, join 7000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
Want to learn more about The Best Interest’s back story? Read here.
Looking for a great personal finance book, podcast, or other recommendation? Check out my favorites.
Was this post worth sharing? Click the buttons below to share!
Source: bestinterest.blog