Inflation and the investor
Why neither bonds nor stocks fully protect you from rising prices, in Graham's data and Zweig's.
FinanceGraham ch. 2About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why fixed payments lose buying power under inflation
- Explain why Graham doubted that stocks are an automatic inflation hedge
- Calculate a real return and the effect of inflation over time
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The Intelligent Investor: Benjamin Graham's ideas: lesson 2 of 25
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Costs and the market
- Is advice worth paying for? 7 min
- Reading the accounts
- The balance sheet always balances 5 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 2, "The Investor and Inflation"
What it is
Inflation shrinks what money can buy. Someone living on a fixed income, such as the interest on a bond, loses buying power as prices rise. Shareholders at least have a chance: companies can raise prices, and dividends and share prices can grow.
In the early 1970s many experts concluded that stocks were always better than bonds. Graham disagreed:
- Over 1915–1970, his figures show the Dow Jones Industrial Average rising about 4% a year (from an average of 77 to 753), plus about 4% a year in dividends: about 8% in total, but no more than good bonds were then paying.
- There was no close link between inflation and stock prices over shorter periods. In 1966–1970, the cost of living rose 22%, yet company earnings and stock prices fell.
His conclusion: stocks may protect against inflation over long periods, but there is no guarantee, and that is a reason to own both bonds and stocks, not stocks alone.
Quick check
Tap an answer to check it.
In Graham's figures for 1966–1970, prices rose 22%. What did stock earnings and prices do?
- That's the theory Graham was testing; it didn't happen
Show answer
They declined. No close short-term link between inflation and stock prices.
Why it matters
Inflation decides what your money is really worth. A return of 8% with 3% inflation leaves about 4.9% of real growth: (1.08 ÷ 1.03) − 1 ≈ 0.049. And it compounds: at 3% a year, prices roughly double in about 23 years.
Worked example
Graham guessed, in 1972, that inflation might run at about 3% a year. Zweig, writing in 2003, points out how wrong that turned out: in 1973 inflation hit 8.7%, and a basket of goods costing 100 at the start of 1973 cost about 230 by the end of 1982.
That's an average of about 8.7% a year for ten years: 2.30^(1/10) − 1 ≈ 0.087. Someone holding a fixed payment of 100 a year would have lost more than half its buying power.
Zweig also looks at all 64 five-year periods from 1926 to 2002: stocks beat inflation in 50 of them (78%), so they failed about one time in five.
Common mistake
Treating stocks as a perfect inflation shield. In Zweig's data, stocks did badly in years of very high inflation (and in deflation). Graham's advice is to expect inflation, but to protect against it with a mix, not with one asset.
Key terms
- inflation
- a general rise in prices, which shrinks what money buys
- real return
- the return after inflation: (1 + return) ÷ (1 + inflation) − 1
- fixed income
- payments set in money terms, like bond interest, which inflation erodes
- inflation-protected bond
- a government bond whose value is adjusted for inflation (Zweig discusses the U.S. version)
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| inflation | a general rise in prices, which shrinks what money buys |
| real return | the return after inflation: (1 + return) ÷ (1 + inflation) − 1 |
| fixed income | payments set in money terms, like bond interest, which inflation erodes |
| inflation-protected bond | a government bond whose value is adjusted for inflation (Zweig discusses the U.S. version) |
Practice
Work it through
Your savings earn 5% a year. Inflation is 4% a year.
- (1.05 ÷ 1.04 − 1) × 100
- 100 × 1.04¹⁰
Quick quiz
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What was Graham's conclusion about stocks and inflation?
- He argued against exactly this
Show answer
Stocks may help over the long run, but they are no guarantee, so hold bonds and stocks. No close link over short periods; balance is safer.
In Zweig's data (1926–2002), in what share of five-year periods did stocks beat inflation?
- They failed in 14 of 64
Show answer
about four in five (78%). 50 of 64 periods.
In short
- Inflation erodes fixed payments; stocks can keep up, but not reliably.
- Graham, 1915–1970: stocks about 8% a year in all, no better than bonds paid in 1972.
- Short term: no close link between inflation and stock prices.
- Real return = (1 + return) ÷ (1 + inflation) − 1.
Mastery check
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Check yourself
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Prices rise 3% a year. Roughly how long until they double?
Show answer
About 23 years (rule of 70: 70 ÷ 3 ≈ 23; exactly about 23.4).
Why did Graham advise holding bonds as well as stocks, even when inflation is around?
Show answer
Because stocks don't reliably keep up with inflation in the short run, so a mix is safer.
What was Graham's inflation guess in 1972, and what happened?
Show answer
About 3% a year; instead inflation reached 8.7% in 1973, and prices more than doubled from 1973 to 1982.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 2.
- On this site: Real and nominal interest rates and Measuring inflation.
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