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Inflation Ahead: What to Know as a Stock Investor

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Treasury Secretary (and former Fed chair) Janet Yellen

Treasury Secretary (and former Fed chair) Janet Yellen

Inflation: The Hidden Destroyer of Wealth

When I was growing up during the 80s, the conventional wisdom was to set aside money to save for the future. My grandparents had lived through the Great Depression, and growing up, I had seen that their cupboards were crowded (if well-organized) salvage yards filled with these weird aluminum cups everyone had stopped using years ago, 30-year-old Mason jars that could be used to preserve tomatoes from their garden for the winter, and all kinds of recycled and reused materials from their kitchen.

The greatest generation understood scarcity because they lived through two different drivers of the scavenger mindset: the Great Depression, during which there often wasn't enough to go around; and World War II, during which the rationing of basic materials so they could be used by the military was considered a patriotic duty (not to mention the law of the land in many places).

Naturally, the importance of always having enough money around was deeply ingrained in the boomer generation, and this way of life was passed along to me and my generation. Saving money is a great way to hold on to wealth, or so the conventional wisdom goes.

There's only one problem. This is completely wrong because of an economic phenomenon that can do as much as anything to destroy wealth during all sorts of conditions, both prosperous and scarce: inflation. Let's take a look at why that is, what can be good about this inevitable phenomenon, and what you can do about it as an investor.

The Bad

While it's nice to imagine that your money will always be worth the same thing over time, inflation poops all over that party. In my own lifetime, I've seen all sorts of prices rise a great deal, but one of the most visible examples I can remember is going to the movies to see Back to the Future in 1985. The average movie ticket was around $3.50, and I remember hunting for the theaters where first-run movies were $3.00 or $3.25.

Similarly, my first car was used and cost me $1500, and my first semester of college cost less than $2000. In other words, the price of pretty much everything goes up over time, everything else being equal.

This means that if you had stuck a $10 bill in your wallet in 1985, you might have thought it was worth three first-run movies. After all, if you just did a little shopping around, you could have bought entry into three movies. How many first-run movies could you watch in a theater today for $10? Could you find one? Could you find a semester of college tuition for $2000? I think you might be hard-pressed to find a semester for less than $10,000 today.

What this all means is that saving money, or simply putting it somewhere, will virtually guarantee that your money loses value, shedding real purchasing power while appearing to look the same all the while. This means that, in order to be able to buy the same thing in the future, you need to have a return on your capital that's at least as high as inflation, and that's the first thing to understand any time you're thinking about saving for the future.

Ah-ha, you're thinking, I can just put my money into a high-yield savings account and get paid for the pleasure of storing my money! Before you laugh maniacally or wipe your hands to signify that you're done thinking about this nuisance forever, it gets even worse: your 0.5% yield has absolutely no chance of keeping up with the historical rate of inflation over the last 20 years—around 3%—and even less of a chance if inflation spikes higher, as many economists and investors say is inevitable. Doh!

The Good

Wait a minute, now . . . how can inflation be good? If you're asking this question right now, you're in good company, but you're also in the right place to get an answer. Given that cash sitting around loses money, it's important to think about who might benefit from such a thing.

Since we know that our investments need to return a rate higher than the rate of inflation in order for us not to lose purchasing power over time, we need to seek out investments with higher returns in order to grow our actual wealth over time; this much we can infer from simple subtraction. But how can we take advantage of this understanding and use it to our advantage?

Reverse engineering is helpful here. If you have an environment where money is worth a lot less over time, and you have money in the bank, it makes sense for you to make a big purchase now—not next year, when your cash might not be able to buy as much of the thing you want.

Think about buying a home that costs $100,000 right now, but the same home is likely to sell for $200,000 tomorrow. Would you rather buy the house with the $100,000 you have in the bank right now, or would you rather buy half of it tomorrow?

Inverting this equation, imagine you run a shop that sells fancy, felt-tipped pens. Today, your pens sell for $10 apiece, and you have 1000 pens in your inventory. You have one buyer for the pens (some kind of creepy collector, most likely) who is ready to purchase all 1000 either today or tomorrow. If you sell the pens today, you'll get $10,000 for them, but if you wait until tomorrow, you'll get $20,000. Assuming you don't have anything to spend the money on, would you rather sell the pens today or tomorrow?

The clear lesson here is that it's far, far better to own real (tangible) assets in an inflationary environment than it is to own cash. This is the most important takeaway, and it is absolutely crucial that you understand that you should invest in businesses, especially those that can control the prices they charge customers, and other tangible assets. As Ray Dalio is fond of saying, cash is trash.

Homeowners and Governments

Dialing this back to a more familiar scenario, imagine you have a mortgage that charges a fixed rate (let's say 5% a year), and you owe $100,000 on your house, which happens to be worth exactly $100,000. You also just happen to have $100,000 in the bank, and you're wondering if it makes sense to pay your mortgage off right now, or if it makes sense to make the $1000 monthly payments and pay it off over the next 30 years. You're also thinking about buying the house next door that went on sale for $100,000 yesterday, and the seller is interested in your all-cash offer of $100,000.

The clear question here is whether inflation is higher or lower than your mortgage rate. Imagine a scenario where hyperinflation takes the reins, and you're seeing prices double every month. After just one month, your $100,000 home is now appraising at $200,000. After a year, it's worth $409,600,000. Now, would you prefer to make the $1000 monthly payments, or would it make more sense to have paid off your mortgage instead?

Very clearly, it makes sense to pay $1000 a month, since that $1000 will be worth far, far less in the future. This is how homeowners can benefit from inflation. In the same way that having your money in a "high-yielding" savings account is a terrible idea, paying off a fixed-rate mortgage slowly is fantastic for you, especially if you're able to put the money you have now to work.

In the same way, there are often thought to be two ways for a government to pay off its debt: either raise taxes or cut spending. It turns out that neither of these options is particularly popular with the electorate, so governments often use the same principle that a homeowner might use to benefit from inflation. As the value of money declines over time, a fixed amount of debt means that it becomes much, much easier to make monthly minimum payments each month.

For the homeowner with a $1000 monthly mortgage in a world where a side of fries costs $10,000, life couldn't be better (at least as far as living expenses go), and for a government that owes $20 trillion, the longer it can take to pay off its debt, the less—in real terms—it will have to pay. The less the government must pay now, the less likely it is to have to institute a vastly unpopular tax increase or cut a popular social program.

The Big Takeaway

Think about how the homeowner (or government) benefits from slowly paying back debt over time and invert your thinking one more time. If you're the recipient of these fixed payments yourself, you're not really happy with inflation, but if you are able to raise your price, you'd be a happy camper indeed.

This means that owning businesses that can raise their prices is a good bet under inflationary scenarios, and owning real assets (houses) is far better than owning cash. Think about the investment opportunities you have through this lens, and you can make far better long-term decisions that can ultimately help keep your wealth from losing value.

Understanding this is crucial to following investing rule number one: never lose money. And, since hiding money under your mattress doesn't actually do this for you, you will need to invest intelligently.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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