The Other Side of Inflation (The Motley Fool)

There's something funny about inflation: how one-sided the criticism is.

Inflation, of course, raises prices, which is bad -- and that's usually where the criticism ends.

But there's another side of inflation: the impact it has on wages and assets. If prices go up 10%, but wages and net worth also rise 10% (or more), are you worse off?

Yale economist Robert Shiller wrote a paper in the 1990s asking people around the world why they feared inflation. While respondents were overwhelmingly fascinated with inflation and feared its wrath, most couldn't gather much more than an emotional response. Shiller wrote:

"When asked why they dislike inflation, people often protest that they are not experts, and they need to be prodded to respond. When they do respond, it is often with what seem to be incompletely thought-out ideas and vague associations about inflation, yet a conviction that inflation is important. Most people seemed to be vulnerable to fundamental confusions about inflation, and in spite of their convictions as to the importance of inflation, seemed not to have given really serious thought to it."

After his interviews, Shiller elaborated: "[T]he main issue for the public with regard to inflation is just that people do not see the connection between inflation and increases in income that might be associated with it."

Might may be the key word there. Over certain periods of time, inflation can, of course, outstrip rising wages. And once you get into a hyperinflationary spiral, like Zimbabwe faced in recent years, people are inarguably worse off.

But those tend to be the exceptions.

At a recent conference with Berkshire Hathaway (NYSE: BRK-B - News) Vice Chairman Charlie Munger, a questioner asked Munger about inflation's "devastation" over the past half-century. In 1950, a corned-beef sandwich at a local diner cost $0.55, the questioner noted. Today it's $10. How can a country be anything but a failure when its currency loses 95% of its value to inflation, he wondered.

Munger's response was characteristically curt: "If you think the past half-century was bad, you will have serious problems in life," he said. "Despite inflation, we've been a huge success. Real GDP has grown 2% per year per capita. That's fantastic. The period you describe as miserable was a tremendous time for the American economy. You've described success."

A few numbers illustrate his point.

A dollar may have lost 95% of its value since 1950 (at least in corned-beef sandwich terms), but that only applies to those who kept cash under their mattress. If the $0.55 it took to buy a sandwich in 1950 were put in a risk-free savings account earning 5%, it'd be worth $11 today. Put in a stock index fund, it'd be worth nearly $200. The real gift of companies like Coca-Cola (NYSE: KO - News) and Altria (NYSE: MO - News) is their ability to raise prices with inflation over time -- something their investors have benefited from handsomely. Only those who shunned all investment return saw their dollars depreciate 95%. And they deserve the outcome they received.

Beyond investments, incomes tend to follow the same path. Despite inflation, things have generally gotten better over time.

Real disposable income -- that's after-tax income adjusted for inflation-- has increased threefold since the early 1950s. Yes, a corned-beef sandwich may have cost $0.55 in 1950, but the average household income back then was $3,900. Today, the average household earns that much every three weeks. Inflation raced along between 10%-13% per year in the early 1980s. But what else grew at roughly the same rate? Incomes.

The Bureau of Labor Statistics has records detailing the percentage of income spent on various items going back to 1901. The improvement in some important areas is astounding. In 1901, 46% of an average income went to food and beverages. By 1950, that was down to 33%. By 1987, 19%. Today, it's 14%. The Consumer Price Index shows about the same: Disposable income has risen twice as fast as food prices over the past 50 years.

There are counterarguments here. Three areas in particular have been hit by genuine inflation over time: housing, education, and health care. Part of this is caused by quality -- homes are bigger, education buys a better income, and health care is more advanced -- but all three, apples-to-apples, are still more expensive today than in the past. Some of why households earn more today is because more women are working, creating two incomes where there used to be one. Inflation gives a general perception that something is wrong, creating uncertainty and fear. And if you're living off a fixed income, you can throw most of this out the window.

But Shiller's point remains: There is another side of inflation that often goes ignored. One doesn't have to argue that inflation is good, but it might not be nearly as bad it looks.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor TMFHousel. The Motley Fool owns shares of Berkshire Hathaway, Altria Group, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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The Key to Beat Inflation in Retirement (The Motley Fool)

Stocks go up and stocks go down, but the one thing you can count on is this: Prices of just about everything you'll need after you retire will go up over time. The challenge is figuring out how to make your retirement investments grow enough to keep up with the rising prices of your basic necessities. But with a little work, you can find the best ways to beat inflation -- and they aren't necessarily where you might expect.

Why inflation is a money-killer
When you talk about ways to lose money, most investors immediately think of stocks prices dropping like a stone during bear markets. The impact that stock declines have on your net worth is obvious: Your brokerage statements tell the tale each and every quarter. When bear markets strike your investments, you'll know about it.

Inflation often isn't that straightforward. Occasionally, big moves like we've seen in oil and food prices lately make it all too clear just how painful rising prices can be. But even the more gradual pace of inflation is enough to reduce the purchasing power of your portfolio considerably over time -- and more importantly, you have to keep your eyes on a moving target if you want to be certain that you'll be able to afford everything you want after you retire.

The obvious inflation plays
Because inflation has been a constant threat for so long, financial products evolved to help fight its effects. In particular, the U.S. Treasury came out with its inflation protected securities, or TIPS, which are bonds whose principal value is indexed to inflation and changes with the Consumer Price Index.

Investors who want to own TIPS have several options. The TreasuryDirect service sells them directly to the public, and many discount brokers allow you to buy TIPS at auction for little or no cost. In addition, mutual funds and ETFs such as iShares Barclays TIPS Bond (NYSE: TIP - News) and SPDR DB International Government Inflation-Protected Bond (NYSE: WIP - News) give you a full diversified portfolio of TIPS and similar instruments from governments around the world.

Another way those in or near retirement can fight rising prices is to buy immediate annuities whose payouts are linked to changes in inflation. Again, these annuities typically use the CPI as a reference point, but by making sure your payouts will rise generally with overall costs, you'll put yourself in a better position to outlast your money and preserve its purchasing power.

Finally, a traditional way that many investors have struggled against inflation is by buying gold. Many remember gold as a lucrative investment during the late 1970s, when double-digit inflation posed a major threat to the U.S. economy. Although it fell out of favor after inflation levels subsided, the popularity and ease of use of the SPDR Gold Trust (NYSE: GLD - News) ETF, along with big jumps from the yellow metal's lows from 10 to 12 years ago, have helped gold recover its reputation as a method for fighting inflation.

Build a better link
But the way I prefer to fight inflation addresses a key argument against CPI-linked measures: that the CPI doesn't accurately reflect a person's own experience of rising prices. Although the CPI is an aggregate measure, everyone's individual tastes lead to a different effective rate of inflation. If you like specialized products, the CPI is unlikely to reflect the price behavior you see in the things you buy.

The key, then, is to connect what you need with investments that prosper when your necessities rise in price. For instance, if you need to protect against higher energy costs, then investing in energy giant Chevron (NYSE: CVX - News) or a broader-based fund like the Energy Select SPDR (NYSE: XLE - News) should help you match higher prices with rising share values.

But what if prices fall? Those stocks might get hurt, creating losses in your investment portfolio and offsetting the benefit you'll get from lower costs for your everyday needs. Still, many retirees might consider that risk worth it in order to hedge against the possibility of wallet-busting price increases.

Get personal
Investing with inflation in mind isn't as simple as it looks. But if you take the time to see what you'll truly need after you retire, you can tailor your portfolio to move up and down with the prices of those necessities. That should give you peace of mind you can't get from any other investment.

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Fool contributor Dan Caplinger likes to win a fight. He doesn't own shares of the companies mentioned in this article. Pfizer is a Motley Fool Inside Value selection. Chevron is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never loses its keys.

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4 Ways Investors Get Inflation Wrong (The Motley Fool)

Between fears of a new oil shock and the Fed's money-printing, it's only natural for investors to be concerned about the risk of inflation. If you want to manage that risk intelligently, make sure the following four myths don't trip you up.

Myth No. 1: Rising oil prices will necessarily cause inflation
It was no coincidence that two oil shocks marred the 1970s, the last period of significant U.S. inflation. However, the link between oil price increases and inflation appears to have weakened since 1980. There's a huge wild card, though: the Fed. In trying to explain why higher oil prices have had less of an effect on inflation over the past 30 years, economists -- including Ben Bernanke -- have seized on increasingly aggressive Fed policy as an explanation. The Fed has shown itself more willing to try to counteract the effects of oil price increases (among other things it's been more willing to get involved in).

Sure enough, last Friday, Fed Vice Chairman Janet Yellen declared that the Fed "couldn't sit by" if higher oil prices started feeding through to inflation. But however much she talks the talk, raising interest rates will be a lot trickier while the economic recovery remains fragile.

Myth No. 2: Inflation is underreported by the government
This is a widespread myth supported by an entire arsenal of false arguments. I think this myth is so persistent because people don't find that the government's consumer price index reflects their experience of inflation. But there are multiple explanations for this that don't require a government conspiracy to underreport inflation.

First, the CPI is an average calculated over an extremely broad basket of goods and services; different people consume different subsets of that basket, so it's quite natural that some people will experience higher-than-average inflation. Second, people may overestimate inflation due to "loss aversion": They feel the loss of purchasing power associated with rising prices more acutely than increases in buying power that result from falling prices.

And falling prices do occur: Last year, for example, Wal-Mart Stores (NYSE: WMT - News) reduced prices on more than 10,000 items, including a 22% price cut on Procter & Gamble's (NYSE: PG - News) Tide laundry detergent, for example. In fact, on exiting the recession, Procter & Gamble proactively waged an aggressive price war against rivals Colgate-Palmolive (NYSE: CL - News) and Unilever (NYSE: UN - News), as well as private label brands. (This year, however, Procter will be raising prices, and I expect its rivals to follow suit.)

Myth No. 3: Gold is an effective inflation hedge
This is a half-myth: As I showed here, gold has preserved purchasing power, but it has only done so reliably over the very, very long term. Over practical holding periods, however, gold doesn't appear to be an effective inflation hedge. Owners of gold-backed products, including the SPDR Gold Shares (NYSE: GLD - News) or the Sprott Physical Gold Trust ETV (NYSE: PHYS - News), are forewarned. There may be good reasons to own gold during certain periods -- the yellow metal offers some diversification with regard to stocks, for example -- but fear of inflation isn't one of them.

Myth No. 4: Stocks are an effective inflation hedge
All right, this last one is no myth. When investors purchase stocks at reasonable prices, they can expect to earn a positive inflation-adjusted return (over an adequate holding period). But it's important to understand one caveat: Stocks don't automatically protect investors during any specific period in which inflation is flaring up.

In the two-year period from 1973 through 1974, the CPI rose 22%; the S&P 500 only added insult to injury, losing 42% of its value. Stocks are a claim on companies' earnings, and, sure enough, S&P 500 earnings grew faster than inflation over that period. "So what went wrong?" you ask. The trouble was that investors didn't want to own stocks and had sold them down to cut-rate valuations, overwhelming the positive effect from earnings growth. The same phenomenon occurred during the inflation spike of 1946-1947.

It's also worth pointing out that not all stocks are created equal in terms of inflation protection. Which companies are best able to pass on rising costs (and more!) to their customers through price increases? Pricing power is the privilege of businesses that are able to differentiate themselves from their competitors or that produce goods or services people must have. The consumer stocks I mentioned earlier fall into that category. If you're concerned about inflation, take comfort in the fact some of the great franchises in American business are available at reasonable prices right now.

If you want specific ideas of inflation-beating stocks, the Motley Fool's top analysts have identified 13 High-Yielding Stocks to Buy Today.

Wal-Mart Stores is a Motley Fool Inside Value recommendation. Wal-Mart Stores is a Motley Fool Global Gains pick. Procter & Gamble is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores. The Fool owns shares of Sprott Physical Gold Trust ETV and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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