The Investor and InflationInflation, and the fight against it, has been very much in thepublic’s mind in recent years. The shrinkage in the purchasingpower of the dollar in the past, and particularly the fear (or hopeby speculators) of a serious further decline in the future, hasgreatly influenced the thinking of Wall Street. It is clear that thosewith a fixed dollar income will suffer when the cost of livingadvances, and the same applies to a fixed amount of dollar principal.Holders of stocks, on the other hand, have the possibility that aloss of the dollar’s purchasing power may be offset by advances intheir dividends and the prices of their shares.On the basis of these undeniable facts many financial authoritieshave concluded that (1) bonds are an inherently undesirable formof investment, and (2) consequently, common stocks are by theirvery nature more desirable investments than bonds. We haveheard of charitable institutions being advised that their portfoliosshould consist 100% of stocks and zero percent of bonds.* This isquite a reversal from the earlier days when trust investments were47* By the late 1990s, this advice—which can be appropriate for a foundationor endowment with an infinitely long investment horizon—had spread to individualinvestors, whose life spans are finite. In the 1994 edition of his influentialbook, Stocks for the Long Run, finance professor Jeremy Siegel of theWharton School recommended that “risk-taking” investors should buy onmargin, borrowing more than a third of their net worth to sink 135% of theirassets into stocks. Even government officials got in on the act: In February1999, the Honorable Richard Dixon, state treasurer of Maryland, told theaudience at an investment conference: “It doesn’t make any sense for anyoneto have any money in a bond fund.”restricted by law to high-grade bonds (and a few choice preferredstocks).Our readers must have enough intelligence to recognize thateven high-quality stocks cannot be a better purchase than bondsunder all conditions—i.e., regardless of how high the stock marketmay be and how low the current dividend return compared withthe rates available on bonds. A statement of this kind would be asabsurd as was the contrary one—too often heard years ago—thatany bond is safer than any stock. In this chapter we shall try toapply various measurements to the inflation factor, in order toreach some conclusions as to the extent to which the investor maywisely be influenced by expectations regarding future rises in theprice level.In this matter, as in so many others in finance, we must base ourviews of future policy on a knowledge of past experience. Is inflationsomething new for this country, at least in the serious form ithas taken since 1965? If we have seen comparable (or worse) inflationsin living experience, what lessons can be learned from themin confronting the inflation of today? Let us start with Table 2-1, acondensed historical tabulation that contains much informationabout changes in the general price level and concomitant changesin the earnings and market value of common stocks. Our figureswill begin with 1915, and thus cover 55 years, presented at fiveyearintervals. (We use 1946 instead of 1945 to avoid the last year ofwartime price controls.)The first thing we notice is that we have had inflation in the

past—lots of it. The largest five-year dose was between 1915 and1920, when the cost of living nearly doubled. This compares withthe advance of 15% between 1965 and 1970. In between, we havehad three periods of declining prices and then six of advances atvarying rates, some rather small. On this showing, the investorshould clearly allow for the probability of continuing or recurrentinflation to come.Can we tell what the rate of inflation is likely to be? No clearanswer is suggested by our table; it shows variations of all sorts. Itwould seem sensible, however, to take our cue from the rather consistentrecord of the past 20 years. The average annual rise in theconsumer price level for this period has been 2.5%; that for1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-48 The Intelligent InvestorTABLE 2-1 The General Price Level, Stock Earnings, and Stock Prices at Five-Year Intervals, 1915–1970Year1915192019251930193519401946c

19501955196019651970Wholesale38.084.556.647.343.843.066.186.897.2100.7102.5117.5Consumer35.469.861.158.247.848.868.083.893.3103.1109.9134.0Earnings1.24.97.76

1.051.062.843.623.275.195.36Price8.317.9811.1521.6315.4711.0217.0818.4040.4955.8588.1792.15WholesalePrices+96.0%–33.4–16.5– 7.4– 0.2+53.7+31.5+ 6.2+ 9.2+ 1.8+14.6ConsumerPrices+96.8%–12.4– 4.7–18.0+ 2.1+40.0+23.1+11.4+10.5+ 6.6+21.9StockEarnings– 21.9%– 21.6+ 33.1+ 1.0+168.0+ 27.4– 9.7+ 58.8+ 3.3StockPrices– 4.0%+ 41.5

+ 88.0– 26.0– 28.8+ 55.0+ 21.4+121.0+ 38.0+ 57.0+ 4.4Price Levela S & P 500-Stock Indexb

Percent Change from Previous Levela Annual averages. For price level 1957 = 100 in table; but using new base, 1967 = 100, the average for 1970 is 116.3 for consumers’ prices and110.4 for wholesale prices for the stock index.b 1941–1943 average = 10.c 1946 used, to avoid price controls.ment policy has been strongly against large-scale inflation, andthere are some reasons to believe that Federal policies will be moreeffective in the future than in recent years.* We think it would bereasonable for an investor at this point to base his thinking anddecisions on a probable (far from certain) rate of future inflation of,say, 3% per annum. (This would compare with an annual rate ofabout 21⁄2% for the entire period 1915–1970.)1

What would be the implications of such an advance? It wouldeat up, in higher living costs, about one-half the income nowobtainable on good medium-term tax-free bonds (or our assumedafter-tax equivalent from high-grade corporate bonds). This wouldbe a serious shrinkage, but it should not be exaggerated. It wouldnot mean that the true value, or the purchasing power, of theinvestor’s fortune need be reduced over the years. If he spent halfhis interest income after taxes he would maintain this buyingpower intact, even against a 3% annual inflation.But the next question, naturally, is, “Can the investor be reasonablysure of doing better by buying and holding other things thanhigh-grade bonds, even at the unprecedented rate of return offeredin 1970–1971?” Would not, for example, an all-stock program bepreferable to a part-bond, part-stock program? Do not commonstocks have a built-in protection against inflation, and are they notalmost certain to give a better return over the years than willbonds? Have not in fact stocks treated the investor far better thanhave bonds over the 55-year period of our study?The answer to these questions is somewhat complicated. Commonstocks have indeed done better than bonds over a long periodof time in the past. The rise of the DJIA from an average of 77 in1915 to an average of 753 in 1970 works out at an annual compoundedrate of just about 4%, to which we ma