Books / Finance · May 13, 2022

Chapter 2 Of The Intelligent Investor Explained For Beginners

Chapter 2 Of The Intelligent Investor – The Investor And Inflation

In this blog, we will be analyzing the Chapter 2 Of The Intelligent Investor – Investor And Inflation. Author Benjamin Graham talks about the mindset of the investor with inflation. According to him, investors are constantly in a fight with inflation.

Graham believes that a person with a fixed income will suffer with the effects of inflation when there is a substantial increase in the cost of living.

Also read: Things You Need To Know About Investment And Speculation

What is inflation

Inflation is defined as a decrease in a currency’s buying power over time. The increase in the average price level of a basket of selected goods and services in an economy over time may be used to calculate a quantitative estimate of the pace at which buying power declines.

It is rise in the overall level of prices, commonly stated as a percentage, indicates that a unit of money now buys less than it did previously.

There is no definite answer on what would the inflation for the next year be as it shows variation of all sorts.

Finding a correlation of inflation with the stock market

The inflation is calculated by 2 parameters:

  1. The wholesale price index
  2. The consumer price index

For the simplicity of the explanation, I have taken the wholesale price index as a benchmark for calculating the inflation.

Consider the following table. Observe the percentage change in wholesale price index vs the percentage change in stock index from 1930 to 1970.

YearPercentage change in wholesale price indexPercentage change in stock index
1930-16.8+88.0
1935-7.4-26.0
1940-0.2-28.8
1945+53.7+55.0
1950+31.5+21.4
1955+6.2+121.0
1960+9.2+38.0
1965+1.8+57.0
1970+14.6+4.4
Wholesale price index vs stock index from 1930 to 1970 (US market, S&P500)

From the observations made from the above table, we can try to find the relationship between the inflation and stock index returns.

  • In the year 1930, the wholesale price index was in negative, still the stock gave a return of 88.0%.
  • In the next year, the wholesale index being slightly negative, the stock index gave a negative return of about 25%.
  • In the year 1955, the wholesale index being just up by 6%, the stock index more than doubled in the same year.

There is no direct relation between the two. The effects of inflation in one year can be reflected in the stock performance in the preceding year and vice versa.

Thus, one can make a conclusion that, the years when the stock market were positive, the stocks were a better investment choices. On the other hand, when the stock index was negative, bond investment would be considered better.

But there is no way we can predict the rate of inflation and the effects it will have on the stock market.

Everyone is affected by the effects of inflation. On a larger time frame, the inflation increases about 4-5% yearly when calculated on an average.

The implications of inflation

  • Higher cost of living
  • Shrinkage in investment returns

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The money illusion

According to Graham, the major reasons why investors outlook the importance of inflation is the concept of “Money Illusion”.

Let us understand this with an example stated in the book.

Consider you receive a 2% raise in your salary in a year, when the inflation was at 4%. You will feel better that your salary has been raised. But if your salary was deducted by 2%, when the inflation was zero, you might feel bad. Yet both the changes in your salary left you with identical situation, that is 2% deduction, but our perspective on both the scenarios were different.

If the change is positive, we view it like its a good thing, even if the real (after inflation) result is negative [Pg. 59, The Intelligent Investor].

Our reaction towards our investments also tend to be the same. We are happy with fixed returns of 6-8% on bonds and fixed deposits. But in reality, if you consider the impact of inflation, the returns are far lower than what is expected.

Inflation and corporate earnings

Another way of studying the market is by trying to understand the relation between the inflation and corporate earnings. The rate of corporate earning tend to fluctuate with the economy of the country, but it has shown no direct relation with the rate of inflation.

It was seen that the profit after tax made by the S&P500 (US stock market index) companies tend to increase year on year. Thus, inflation has been benefited the companies in terms of earning.

Choosing investments that beats inflation

Investing all in stock is a bad decision, as the returns may turn out to be negative even in the conditions when the rate of inflation is positive.

On the other hand, investing in bonds and fixed deposits can also severely impact the overall value of investment over a longer time frame.

The following graphs depicts the relation between the inflation and the stock market returns.

Inflation vs stock returns

Hedging against inflation

According to the Author, diversification of portfolio is the best hedge against inflation. Thus, it depends on the risk appetite of the investor on how he would like to diversify it. But one must note that, diversification is important. An intelligent investor must not put 100% of his capital in a same asset class, even be it in stocks.

Some other alternatives of hedges against inflation as discussed in the book

Investing in gold

Since gold has its own intrinsic value, it will tend to appreciate with time. Hence, this appreciation in the prices of gold will be in line with the rise in the rate of other commodities, thereby making your investment grow with inflation.

Investing in real estate

As per the author, real estate investing has been regarded an excellent long-term investment. The rationale for this is that real estate may be used as a hedge against investment, since the rental return of the assets might rise in tandem with inflation. This can provide significant inflation protection.

Conclusion

In conclusion, referring to Pg. 56 of the book, which states that “Just because of the uncertainties of the future, the investor cannot afford to put all the funds into one basket. Neither in the bond markets, considering the safe returns or in the stock markets, considering the high risk”

Thus, one must make a thorough diversification to reduce the effects of inflation on our assets and yet try to maintain returns above it.

Also Read: Chapter 8 Of The Intelligent Investor Explained For Beginners

Also Read: Chapter 20 Of The Intelligent Investor Explained For Beginners