Inflation

WHEN WE DISCUSS investment performance, we typically talk about nominal returns. But as an investor looking to increase your wealth, what you should care about are real returns, which are your results over and above inflation.

Lower inflation is typically good for investors, because it’s a sign of economic stability—an environment where financial markets tend to flourish. Folks are also less likely to notch investment gains, only to discover that those gains are matched by inflation, so they’re no better off in real terms. Factor in taxes, and things might be even worse.

Let’s say you sell a stock that’s climbed 10% in a period when inflation rose 9%. After paying 15% in long-term capital gains taxes, you would be left with 8.5%, below the inflation rate. The math can be even more grim with bonds. Most bonds pay a fixed rate of interest, so inflation represents an unrecoverable subtraction from a bond investor’s real return—unless that inflation subsequently turns to deflation.

By contrast, stocks can fare okay if inflation is high. Initially, accelerating inflation may depress share prices. But corporations can typically adjust to higher inflation, by raising the price they charge for their goods and services, thus compensating for any increase in wages and the cost of materials. That means corporate earnings can continue to grow faster than inflation. Assuming share prices rise along with those higher corporate earnings, stock investors will enjoy inflation-beating gains.

Next: Economic Growth

Previous: Asset No. 1: Stocks

Articles: Why Rates Matter and Slipping Away