Do you think of inflation being one of your prime enemies? You believe it or not, inflation can make you a millionaire? How? Well, you may be aware that every year the prices of goods and services increase a little in price. The bill of $1 in 1913 would cost you nearly $23 in 1913. But, why best inflation protection is good in stock investing?
What would you do if I ask you to buy your stuffs today for $50 or for $52 tomorrow? Most likely you would choose to buy those stuffs today for buying them cheap. Inflation works in the same way. Every governments like a little bit of it for three reasons.
When you consume more, your purchases of stuffs start generating employment and wealth in the society. The Fed does this through increasing dollars in the economic system so that prices slowly increase over the time. Here in this context an important notion you need to understand the meaning of nominal dollar and real dollar. Nominal dollar doesn’t account for inflation whereas real dollar does. If your grandpa says that he earned $1 an hour in 1913, he’s actually earned $1 nominal dollar which is equivalent to nearly $23 real dollar today.
Every government likes a little inflation because you’re being taxed on nominal dollars. Let’s assume that you’ve bought an asset for $10,000. Next year the price of the asset would be $10,300 if the prevailing inflation rate is 3% Now the most important aspect is that there is actually no real appreciation on the value of the asset you bought. Since you’re being taxed on the nominal value of $300 gain, the inflation itself taxes you. Eventually you can sell out your asset next year, but you’re unlikely to buy more assets with that money. You actually have a little less because you’ve to pay your taxes.
You may be aware that debts are issued in nominal terms. Every government has a huge debt. That enormous amount of debt is easier to pay back as time passes on. This is because the money supply gradually inflates. From a government standpoint, it is good for them to pay back debt. But too much inflation is detrimental to an economy because it creates uncertainty for lenders, consumers, companies or exchange rate. There will be less spending and investment that in turn create lesser employment or wealth in society. High level of inflation means that you’ve to live on fixed incomes and experience lesser buying power for your money as time marches on. So you’ll be more interested in what you can buy for your money, not how much money you have.
Like government, you’re also interested in the real value of your debt. You probably value dollars with respect to what you can buy with real value of dollars. Being a stock investor, you need to understand the role of inflation in economy. For your ease of understanding, just assume that you made a 10% nominal annual return on your stocks and if the inflation was 2%, you have a real return of approx 8%.
And if you had invested $1 in 1913 in a 10% annual returning (RoE) stock, you or your legal heir would have gotten as much as $13,781 in 2013. But with 2% annualized rate, that huge amount would have ended up with only $2,200 real dollars a century later. Whatever may be your return in inflationary world, as a stock investor it is not that bad as it sounds. Debts, in general are severely impacted by it. But stocks are partially impacted by inflation.