THE MONEY ILLUSION - INVESTMENT STRATEGY

THE MONEY ILLUSiON
There’s another reason investors overlook the importance of
inflation:
What psychologists call the “money illusion.”
If you receive a 2% raise in a year when inflation runs
at 4%, you will almost certainly feel better than you will
if you take a 2% pay cut during a year when inflation is
zero. Yet both changes in your salary leave you in a virtually
identical position—2% worse off after inflation. So long as
the nominal (or absolute) change is positive, we view it as a
good thing—even if the real (or after-inflation) result is negative.
And any change in your own salary is more vivid and specific than
the generalized change of prices in the economy as a whole.
Likewise, investors were delighted to earn
11% on bank certificates of deposit (CDs) in 1980 and are bitterly
disappointed to be earning only around 2% in 2003—even though
they were losing money after inflation back then but are keeping up
with inflation now. The nominal rate we earn is printed in the bank’s
ads and posted in its window, where a high number makes us feel
good. But inflation eats away at that high number in secret.
Instead of taking out ads, inflation just takes away our wealth.
That’s why inflation is so easy to overlook—and why it’s so important to measure your
investing success not just by what you make, but by how much you
keep after inflation.
More basically still, the intelligent investor must always be on guard
against whatever is unexpected and underestimated. There are three
good reasons to believe that inflation is not dead:

• As recently as 1973–1982, the United States went through one
of the most painful bursts of inflation in our history. As measured
by the Consumer Price Index, prices more than doubled over
that period, rising at an annualized rate of nearly 9%. In 1979
alone, inflation raged at 13.3%, paralyzing the economy in what
became known as “stagflation”—and leading many commentators
to question whether America could compete in the global market-
place.4 Goods and services priced at $100 in the beginning of
1973 cost $230 by the end of 1982, shriveling the value of a dollar
to less than 45 cents. No one who lived through it would scoff
at such destruction of wealth; no one who is prudent can fail to
protect against the risk that it might recur.
• Since 1960, 69% of the world’s market-oriented countries have
suffered at least one year in which inflation ran at an annualized
rate of 25% or more. On average, those inflationary periods
destroyed 53% of an investor’s purchasing power.5 We would be
crazy not to hope that America is somehow exempt from such a
disaster. But we would be even crazier to conclude that it can
never happen here.
• Rising prices allow Uncle Sam to pay off his debts with dollars
that have been cheapened by inflation. Completely eradicating
inflation runs against the economic self-interest of any government
that regularly borrows money.
HALF A HEDGE
What, then, can the intelligent investor do to guard against
inflation?
The standard answer is “buy stocks”—but, as common answers so
often are, it is not entirely true.
For each year from 1926 through 2002, the relationship between
inflation and stock prices. In years when the prices of consumer
goods and services fell, as on the left side of the graph, stock
returns were terrible—with the market losing up to 43% of its value.
When inflation shot above 6%, stocks also stank. The stock market
lost money in eight of the 14 years in which inflation exceeded 6%;
the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs
of their own raw materials on to customers, high inflation wreaks
havoc—forcing customers to slash their purchases and depressing
activity throughout the economy.
The historical evidence is clear:
Since the advent of accurate stock-market data in 1926, there have
been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932,
and so on through 1998–2002). In 50 of those 64 five-year periods
(or 78% of the time),stocks outpaced inflation.9 That’s impressive,
but imperfect; it means that stocks failed to keep up with inflation
about one-fifth of the time.
TWO ACRONYMS TO THERE S CUE
Fortunately, you can bolster your defenses against inflation by
branching out beyond stocks. Since Graham last wrote, two
inflation-fighters have become widely available to investors:
REITs. Real Estate Investment Trusts, or
REITs (pronounced “reets”), are companies that own and collect
rent from commercial and residential properties.
Bundled into real-estate mutual funds,REITs do a decent
job of combating inflation. The best choice is Vanguard
REIT Index Fund; other relatively low-cost
choices include Cohen & Steers Realty Shares, Columbia
Real Estate Equity Fund,and Fidelity Real Estate Investment
Fund. While a REIT fund is unlikely to be a foolproof inflation-fighter,
in the long run it should give you some defense against the
erosion of purchasing power without hampering your overall returns.
TIPS.
Treasury Inflation-Protected Securities, or TIPS, are U.S.
government bonds, first issued in 1997, that automatically go up in
value when inflation rises. Because the full faith and credit of the
United States stands behind them, all Treasury bonds are safe from
the risk of default (or nonpayment of interest). But TIPS also guarantee
that the value of your investment won’t be eroded by inflation. In
one easy package, you insure yourself against financial loss and the
loss of purchasing power.
There is one catch, however. When the value of your TIPS bond
rises as inflation heats up, the Internal Revenue Service regards that
increase in value as taxable income—even though it is purely a paper
gain (unless you sold the bond at its newly higher price). Why does
this make sense to the IRS? The intelligent investor will remember the
wise words of financial analyst Mark Schweber: “The one question
never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax
complication, TIPS are best suited for a tax-deferred retirement
account like an IRA, Keogh, or 401(k), where they will not jack up your
taxable income.
You can buy TIPS directly from the U.S. government at
www.publicdebt.treas.gov/of/ofinflin.htm, or in a low-cost mutual fund like
Vanguard Inflation-Protected Securities or Fidelity Inflation-Protected
Bond Fund. Either directly or through a fund, TIPS are the ideal substitute
for the proportion of your retirement funds you would otherwise
keep in cash.
Do not trade them: TIPS can be volatile in the short run,
so they work best as a permanent, lifelong holding. For most investors,
allocating at least 10% of your retirement assets to TIPS is an intelligent
way to keep a portion of your money absolutely safe—and entirely
beyond the reach of the long, invisible claws of inflation.