So i was doing some research on inflation and i came across this sentence, "The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night since historically stocks have been quite good hedges against inflation." from https://www.investopedia.com/university/inflation/inflation4.asp at the start of the 2nd paragraph. Can someone please explain why is that?
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3Do you understand the meaning of the word "hedge" as it is used here? If you do not, then that's the place to start.– Eric LippertCommented Apr 29, 2019 at 15:28
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3 Answers
Inflation is a decline in the value of money, but companies can generally adjust their prices to account for that decline.
Take a simple example. Say company X is producing widgets that sell for $100, and makes $10 profit on each one (which it pays to shareholders as dividends). Now you have 10% inflation, so the company changes the price to $110 and makes $11 profit, which is exactly the same after adjusting for inflation. Thus the value of the company in real terms hasn't changed.
Every security that is not cash is a hedge of inflation.
Inflation means the value of cash goes down over time. That means the "relative value of other things over cash" goes up (think of smaller denominator, bigger number).
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The key part of this is "Inflation means the value of cash goes down over time". Everyone thinks "inflation means that the price of everything goes up", but your phrasing makes it clear that any non-cash asset is some sort of hedge against inflation. Commented Apr 29, 2019 at 14:22
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I think not every investment. Say you invest in bonds that pay 4% when the inflation rate is 2%, giving you a real return of 2%. Now a couple of years later the inflation rate jumps to 10%, meaning inflation takes 6% of your investment.– jamesqfCommented Apr 29, 2019 at 15:22
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8@jamesqf: You're not doing all the math necessary. The things to compare are not the profit or loss of the investment in bonds as bond rate changes. The things to compare are the strategies "invest in bonds" vs "keep it all in cash". Say you invest in bonds, blah blah blah, and you lose 6%. Now compare that to keeping it all in cash, where you lose 10%. That's why an investment is a hedge. A hedge doesn't mean that you always make a profit; sometimes it means that you take a smaller loss. Commented Apr 29, 2019 at 15:24
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2@EricLippert You might not take a smaller loss if your bonds are long-term and cash savings accounts raise their rates in response to the inflation jump. The key here is that bonds are fixed-income assets, where you pay cash and agree to receive a certain amount of cash in the future. They are cash-equivalents, and are affected by inflation in a similar way to cash itself.– EarthCommented Apr 29, 2019 at 16:57
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1If what you're pointing out is that some investments are worse hedges than others against inflation, I think you'll find widespread agreement on that point. The original question was why stocks are a good hedge, not why bonds are a poor one. This answer and the comments fail to directly address the central point of the question. Lets concentrate on that rather than going off on tangents. Commented Apr 29, 2019 at 17:19
One has to keep in mind that companies have already invested in buildings, factories, vehicles, real estate, other equipment and other assets. As inflation increases, the value of assets that they already own may become more valuable because they would be more expensive to replace. This may make a barrier to entry for competitors to start a competing business because they would have to purchase these assets at a higher price.
However, there is another side to the same coin. Often, central banks respond to inflation by raising interest rates. When this happens, the cost to borrow money increases, which increases businesses expenses. If customer's wages are not rising at the same rate as inflation, companies may find that if they raise prices, customers may not buy as much. Therefore, they may not be able to fully absorb higher costs. This might be a factor that decreases the value of a company.
Another thing happens when central banks raise interest rates. If they do, this might be reflected in the value of bonds. Bond interest rates are likely to rise (dropping the value of existing bonds). This may make bonds relatively more attractive than stocks with the result that people sell stocks and buy bonds instead. This would tend to push prices for stocks down.
Therefore, "inflation" may either increase a company's value or decrease it depending on which factors are most influential. So, even though some companies may become more valuable when inflation increases, others may become less valuable.
We are going through a high rate of inflation today. The Federal reserve has responded with interest rate hikes and the overall stock market has dropped as a result. Therefore, at least as of December of 2022, the factor of rising borrowing costs along with consumer
incomes that are rising less quickly than inflation appears to have dropped the value of stocks.
