A recession or bear market are not the most significant risks investors face today. The most significant risk is, in fact, inflation.
Investors often overlook the effects of inflation because they are not immediately apparent.
A bear market, where stocks fall 20% or more, immediately has a huge and detrimental effect on your wealth.
Inflation, on the other hand, which is currently running in the region of 2% per annum in the U.S. (the annual inflation rate in the U.S. fell to 1.9% in December of 2018 from 2.2% in November), is more of a silent killer. Two percent per annum might not seem like much over the space of 12 months, but over the space of, say, a decade, it can be exceptionally damaging.
Warren Buffett (Trades, Portfolio), the Oracle of Omaha, has been talking about the scrooge of inflation in his letters to investors of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) since the 1970s.
Warren Buffett (Trades, Portfolio) on inflation
In May 1977, Buffett pending article for financial magazine Fortune, in which he alerted readers to the risks of inflation and how rising prices can hamper growth "not because the market falls, but in spite of the fact that the market rises."
Buffett's article goes against conventional wisdom that stocks are a hedge against inflation. In fact, he said that this view is downright wrong because "stocks, in economic substance, are really very similar to bonds."
The Oracle of Omaha then went on to set out why he held this view. He noted that in the post-war years up to 1975, the average return on equity capital for companies in the Dow Jones Industrial Average was around 12%. Looking at these businesses as productive enterprises, not listed stocks, where owners had acquired the businesses at book value, employs a consistent return of around 12%, he said. "And because the return has been so consistent, it seems reasonable to think of it as an 'equity coupon,'" Buffett wrote.
But as inflation increased during this period, the return on equity capital remained constant. Therefore, Buffett noted, "Essentially, those who buy equities receive securities with an underlying fixed return just like those who buy bonds."
He went on to say that, unlike bonds, stocks are perpetual and equity investors in stocks are "stuck with whatever return corporate America happens to earn." As a result:
"If corporate America is destined to earn 12%, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase. So, score one for the bond form. Bond coupons eventually will be renegotiated; equity “coupons” won’t."
In a low interest rate environment, a 12% return on equity capital is a highly attractive proposition. But inflation is already starting to rise, input costs are growing thanks to tariffs and companies are starting to increase prices. Interest rates are going up and may only increase further as price rises filter through to the economy. With assets already priced for perfection, there is limited scope for equities, stocks bonds and other assets such as real estate to increase in value, thus making them less attractive as inflation increases. Companies may be able to increase the prices they charge consumers, but these will be offset by higher input costs and, thus, profits will likely remain constant.
Meanwhile, inflation will act as a tax on the returns investors are able to pocket, which is dividend income. Buffett gave the following example in his essay:
"The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn’t seem to notice that 6% inflation is the economic equivalent."
This is something to consider for all investors. Inflation and the effects it can have on your wealth are not to be ignored.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Ă‚
Joel Greenblatt, Jellybeans and the Stock MarketÂ
