There's a myriad of factors that eat away returns on investments. Inflation, the rate at which prices rise, is a consistent one that receives more discussion than other factors that eat away returns. Graham (pg.50) wants the intelligent investor to assume a rate of inflation at around 3% because inflation was sitting at around an annual rate of 2.5% between 1915-1970. Why so high a rate to consider? Graham is a conservative spender. He wants to preserve as much money as he can and at the same time he recognizes that when things get bad with the market, things get horrible. He's writing with the Great Depression in mind as well, historical context more than likely telling him that maybe 3% inflation is a good assumption to invest around. If you invest in a bond that gives a 4% return on your investment, assume that inflation is at 3% and you will more than likely be investing in a very different manner. For him, bonds are a questionable investment when in the light of inflation. Because those returns tend to be fixed at a certain percentage, they will get hammered badly by inflation, and if inflation hits a record high like 8.7%, that Zweig adds in as an asterisked commentator's note on pg.50 when Nixon was president, which means there was negative return on bond investments between 1973 and 1982, stocks become a more favorable investment. But not because Graham becomes suddenly trusting of stock investments and dividend returns but because SOMETHING has to do better than bonds, and stocks have the POTENTIAL to outperform bonds. But on page 51 his language switches.
"This brings us to the next logical question: is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades? Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so." (pg.51)
On the same page he extends his discussion to inflation and how they've affected, if at all, corporate earnings. "...it has shown no general tendency to advance with wholesale prices or the cost of living. Actually this rate has fallen rather markedly in the past twenty years in spite of the inflation of the period." On page 52, "The only way that inflation can add to common stock values is by raising the rate of earnings on capital investment. On the basis of the past record this has not been the case...It was generally felt that a "little inflation" was helpful to business profits. This view is not contradicted by the history of 1950-1970...But the figures indicate that the effect of all this on the earning power of common-stock capital ("equity capital") has been quite limited; in face it has not even served to maintain the rate of earnings on the investment." (Pgs. 52-53)"
"...the investor has no sound basis for expecting more than an average overall return of, say, 8% on a portfolio of DJIA-type common stocks purchased at the late 1971 price level." (pg.54) Now he's starting to sound like typical common investor knowledge. Typical investment knowledge dictates that you might see 7%-10% return from the market. 8% is rather low but at the same time Graham, being a conservative, doesn't hold his breath for the best to happen with his money. Yet even he knows that his advice isn't an absolute, because he knows that some years the market will drop worse than other years. Inflation being a constant, you'll lose a lot of money if you have all stock holdings, suffer a down year, and then have to account for inflation on top of your losses. (pgs. 54-55) Not only that but there's the behavioral dynamic of investing as well, noting that "...if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or distressing declines." He does account for human factors in investing, knowing that people will get scared and sell or get too confident and buy when they should do one, the other, or neither of those things, and further wound themselves.
This is what Graham has to say about gold being used as a hedge against inflation: "The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935-LUCKILY FOR THEM (emphasis mine)...The near complete failure of gold to protect against a loss in the purchasing power of the dollar must cast grave doubt on the ability of the ordinary investor to protect himself against inflation by putting his money in "things". (pg.55)
On to real estate: "The outright ownership of real estate has long been considered as a sound long-term investment, carrying with it a goodly amount of protection against inflation. Unfortunately, real estate values are also subject to wide fluctuations; serious errors can be made in location, price paid, etc; there are pitfalls in salesmen's wiles." (pg. 56)
The possibility of large scale inflation eating away your returns is a real one. Graham wants to keep as much of his investment returns as possible, so you cannot afford to put all of your funds into one basket, "neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation." (pg.56)
Zweig adds into his commentary on page 63 that good hedges against inflation that we have are REITs and TIPS, with the latter being especially useful in a tax-deferred account like an IRA or a 401K, where they won't mess with your taxable income (TIPS' increase in value is seem as taxable income, which made OP's tax filings super fucking difficult)
Okay so adding inflation and other sundry costs (Peter Lynch in One Up on Wall Street mentions to add in magazine subscription costs, newspapers, traveling to seminars, and all those sundry costs regarding your investing hobby or career into your returns that year as well because they go to you making hopefully better investment decisions) eats away at your returns. Considering we've had a great bull run for the past ten or so years, the eaten away returns might be negligible, but Graham would fret over it because it's all about keeping as much of your returns as possible. Do your best to not lose wealth at all. While inflation currently sits at around 1%-3% a year, there's been years where it has skyrocketed, so the investor must be adequately prepared for that sort of thing. Stocks and bonds will help, and Zweig adds his commentary to include TIPS and REITs can help as well.
What about you? How do you account for inflation in your investment portfolios? Do you quite frankly care if inflation eats away say 2% of your returns? If you don't care, then why? Is it negligible if you're not trying to actively beat the market? What are your thoughts on this chapter?
Submitted March 16, 2018 at 09:28PM by howtoreadspaghetti http://ift.tt/2FNPK7O
