It’s all over the news. Inflation, or the Consumer Price Index (CPI), at 7.9% is higher than it’s been in over 40 years.
If you stuff your money under a mattress and inflation stays at this level (let alone increases, which it may well do), every $100 bill will be worth just $92.10 this time next year, $84.82 a year later, $78.12 the year after, and $43.91 in a decade.
Yikes!
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There Are Better Alternatives Than Cash
“Well,” you may think, “I’m not keeping my money under the mattress! I have it in an interest-bearing savings account.”
According to Business Insider, the average savings account interest was recently an underwhelming 0.07%.
Great, instead of losing 7.9% per year, you’d be losing “only” 7.83%!
Some savings accounts do pay more though. Business Insider found ones paying 7x higher interest, at 0.5%. Bankrate found accounts paying even more, up to 0.9%.
Still not so great. You’d lose 7%/year buying power there. After a decade of that, your $100 bill would still be worth just $48.40.
Certificates of Deposit (CDs) aren’t much better, with the average 5-year CD paying around 0.4%, and the best paying 1.6%. Here, you’d be losing 6.4%/year. After a decade, your $100 would be worth a whopping $51.47!
And money markets accounts pay only about half as much, so no safety there.
Another option is so-called “I bonds,” sold by the US Treasury. These now offer 7.12% interest, according to the US Treasury website. At that interest rate, your current $100 would be worth $87.36 in 10 years.
How about Treasury Inflation-Protected Securities (TIPS)?
10-year TIPS recently offered a real yield to maturity of -0.589% according to TipsWatch. Here at least your money is almost safe, with today’s $100 worth $99.41 in 10 years.
What About the Stock Market?
If even inflation-protected bonds can’t preserve your money’s buying power, can your stock portfolio do better?
To answer that, I downloaded a copy of Yale economist Robert Shiller’s stock market data, dating all the way back to 1871, and analyzed the correlation between the trailing 12-month inflation rate and the real return of stocks over the following year.
The results are fascinating.
In brief, stocks tend to perform more poorly in the year following a high 12-month inflation rate than when inflation is tame. This makes sense, because companies’ earnings will be paid in future dollars, which will be worth less if inflation continues.
However, things are not completely grim.
What Stock Market Data Show
Here’s a graph showing the average real return of stocks in the following year vs. the prior year’s inflation rate.
As you see, average real returns are highest when inflation is negative, or deflationary, by more than 5%.
When inflation is between -5% and +5%, returns aren’t as high, but are still a very healthy 9.9%.
When inflation accelerates to between 5% and 15%, real returns drop. A lot – to 3.6%.
When inflation goes really high (for a developed economy), above 15%, returns drop a bit more, to an average of 3.1%.
What Hides in Averages
The problem is that stock market returns aren’t at the average rate very often. Instead, they run the gamut from a lot higher to a lot lower.
In the worst deflationary periods, returns varied from a 151.3% gain (that’s right, $100 invested for a single year went up to $251.30!) to a loss of 58.1% (your $100 would have dropped sickeningly to $41.9!).
In the most inflationary periods, that 3.1% average annual return hides a range of returns from a 41.2% gain to a 14.8% loss.
So, does this mean we have to suffer the anxiety of those worst-case scenarios, praying we don’t relive them?
Well, praying rarely hurts, but perhaps a better way to look at things isn’t to focus on the absolute best and worst cases, but rather to look at returns between one “standard deviation” above the average to one standard deviation below the average.
That range should cover a bit more than 2/3 of possible outcomes. You’d only have about 1 chance in 6 of doing better than the high end, and about 1 chance in 6 of doing worse than the low end.
Here’s a graph showing those ranges for the same 4 inflation “bins” used in the previous graph. In red, I added what things look like when inflation runs between 6% and 10%, about ±2% relative to recent inflation rates.
As you can see, extreme deflation brings the most uncertainty, with 68% of historic outcomes ranging from a 39.7% gain to a 15.3% loss. That’s a 55%-wide range!
For the other bins, the range is at most about 37% wide.
Historical data thus tell us that when inflation is within about 2% of where we stand now, a stock portfolio had a 68% chance of resulting somewhere between a 21.2% gain and losing 12.8%.
How Does This Compare to the Overall Historical Record?
If we ignore inflation and look at all 1790 rolling 12-month periods from 1872 to the present, we find an average real return of 8.7%, with 68% of the periods ranging from a gain of 28.1% to a loss of 10.6%.
This means that periods of relatively high inflation, like we have now, have in the past reduced the likely high end of gains from 28.1% to a still very healthy 21.2%. On the low end, those periods typically experienced just slightly worse losses than the general record – 12.8% loss instead of 10.6% loss.
If you’re more of a numbers and tables kind of guy or gal, rather than a visual one, here’s everything in tabular form. The red line is for inflation rates similar to our current levels, reflecting a subset of the +5% to +15% line’s data.
As you can see, of the 1790 rolling periods, 1193 (2/3 of periods) experienced somewhere between mild deflation and mild inflation. Only 184 (about 1 in 10 periods) experienced inflation rates similar to recent levels, and only 218 (about 1 in 8 periods) experienced higher inflation than recent readings.
How I’ve Positioned My Own Portfolio in Response
I’m not the typical investor. I’ve almost always been far more aggressive than most financial advisors or Certified Financial Planners may recommend, staying nearly 100% in stocks. That changed after my portfolio crushed the S&P 500 in 2020, returning nearly 40%.
At that point, knowing I’m only a few years from when I want to be able to retire, I decided to take my earnings that were above my long-term assumed projection of 7%/year and move them to cash equivalents, bringing my cash position to about 30%.
I also moved out of my overweighting in tech to a much more value-oriented position with 20% of my stock position in shares of overseas companies.
Then, when I saw inflation spiking, I moved 10% from cash to a floating-rate mutual fund, leaving 20% in cash. Unfortunately, this last move hasn’t helped much yet, with a 3-month loss of about 1% relative to cash, but better than the S&P 500’s loss of 1.6% in the same time.
Having done all this, and despite increasingly dire warnings of a coming recession, I’m standing pat.
I have no doubt that the stock market will crash sooner or later. It always does at some point. And if the professional prognosticators are right, it’ll be sooner, not later.
When that happens, rather than panic-sell at the bottom of the market, locking in losses, I plan to start redeploying my cash and floating-rate positions back into stocks. Then, when the market recovers, as it always does (on average within 2-3 years), my gains will be supercharged by the shares purchased near the bottom.
The Bottom Line
High inflation is good for only one thing – it reduces the real value of money you owe. If you own a house and have a large mortgage balance, your debt’s real value dropped by 7.9% more in the past year than whatever principal you’ve paid down.
For stocks, high inflation cuts the average return in the following year roughly in half, with slightly greater likely losses, and much lower likely gains.
However, as far as I’m concerned, I’d prefer the historic average of about 4.2% gain following a year of high inflation (e.g., between 6% and 10%) with the majority of my portfolio, rather than the guaranteed loss of purchasing power of cash, savings accounts, money market, CDs, I bonds, and even TIPS. I’m even willing to accept the likely worst case of a 12.8% loss in stocks along with a likely best case of a 21.2% gain.
If you can stomach the risks and gyrations of the stock market, you may want to consider staying in the market, possibly with a healthy cash cushion you can redeploy into stocks once the market drops. Or ask your financial advisor what they recommend based on your individual circumstances and investment horizon.
About the Author
Opher Ganel is an accomplished scientist, instrument designer, systems engineer, instrument manager, and professional finance writer and frequent contributor to Wealthtender.
