Comment on Chapter 2

 Americans are getting stronger by the day. Twenty years ago, it took two people to lift a ten-dollar grocery bag. Today, even a five-year-old can lift it.

Inflation? Who cares?After all, between 1997 and 2002, the annual increase in the price of goods and services averaged 2.2%, and economists believe even this lowest point rate is exaggerated. (Consider for a moment how much the prices of computers and home electronics have fallen, and how the quality of many goods has improved, meaning customers are getting better value for their money.) In recent years, the real inflation rate in the United States has been about 19% annually. This increase is so low that many experts have claimed inflation is "dead."

Another reason investors ignore the importance of inflation is what psychologists call the 'wealth illusion'. If you get a 29% pay rise in a year when inflation is running at 4%, that will surely seem better to you than if you get a 20% pay cut in a year with zero inflation, when in fact you get the same pay (296% less after inflation). As long as the nominal (or absolute) change is positive, we consider it good, even if the real (or after inflation) result is negative. And any change in your pay is more specific and distinctive than the overall change in the economy.' Similarly, in 1980, investors were happy with the 119% return on bank certificates of deposit (CDs) and were quite disappointed with the roughly 2% return in 2003, even though in the past they were losing to inflation, while now they are matching inflation. The nominal rate we get is written in the bank's advertisements and on its windows, where we like the high marks. But inflation secretly eats away at it. Inflation does not affect advertisements, but our wealth. This is why inflation is so tolerated and overlooked, and this is why the measure of success in investing is not how much you are getting, but how much you have left after inflation.More fundamentally, the intelligent investor must always be wary of the unexpected and the unforeseen. There are three good reasons to believe that inflation is alive:As recently as 1973-1982, the US experienced the most severe inflation in its history. As measured by the Consumer Price Index, prices more than doubled during this period, rising at an annual rate of almost 9%. As early as 1929, inflation reached 13.3%, crippling the economy, and leading to what many commentators called 'stagflation', leading to widespread criticism of the US government's decision to impose a new economic crisis.

raised questions about whether the U.S. could compete in global markets. Goods and services that cost $100 in early 1973 cost $230 by the end of 1982, shrinking the value of a dollar to less than 45 cents. No one who has lived through this would joke about such destruction of wealth. No sane person would fail to hedge against the risk that it could come back.Since 1960, 69% of market-based countries around the world have suffered at least one year in which annual inflation reached 25% or more. Those periods of inflation destroyed investors' purchasing power by an average of 53%.' It would be foolish to think that the United States could somehow escape such devastation, but we would be even more foolish to think that it will never happen again.Rising prices allow Uncle Sam to pay back debts in dollars, which have become cheaper because of inflation. The complete elimination of inflation is against the self-interest of any economy that regularly borrows money.'

So what can the intelligent investor do to avoid inflation? The standard answer is 'buy shares', but this is not entirely true, as common answers often are.Figure 2-1 shows the relationship between inflation and stock prices from 1926 to 2002.As you can see, in years when prices of consumer goods and services fell, which is on the left side of the graph, returns from stocks also suffered, with market value declining by 4.3%. When inflation rose above 6%, which is the years on the Y side of the graph, stocks also sank. The stock market suffered in all of the 14 years in which inflation was above 69%. The average return over these 14 years was just 2.6%.While high inflation allows companies to pass on the higher costs of their raw materials to customers, high inflation is destructive, forcing consumers to cut back on their purchases and leading to a slowdown in the overall economy.The historical evidence is clear: since the advent of pure stock market data in 1926, there have been 64 five-year periods covering these (i.e., 1926-1930, 1927-1931,1928-1932, and then 1998-2002). In 50 of these 64 five-year periods (or 78% of the time), stock prices exceeded inflation. This is impressive but imperfect. It means that stocks failed to beat inflation about one time out of every five.

two short names to avoidFortunately, you can use something other than stocks to hedge against inflation. As Graham concluded, for investors, there have always been two warriors against inflation.REITs Real estate investment trusts, or REITs (pronounced reets), are companies that own and collect rents on commercial and residential properties." When combined with real estate mutual funds, REITs offer a strong fight against inflation. One of the best is the Vanguard REIT Index Fund. Other relatively inexpensive options include the Cohen & Steers Realty Shares, the Colivia Real Estate Equity Fund, and the Fidelity Real Estate Investment Fund. Although a REIT fund isn't foolproof against inflation, over the long term it does provide you protection against a drop in purchasing power without sacrificing your overall return.TIPS Treasury Inflation Protected Securities, or TIPS, are U.S. government bonds. First issued in 1997, they automatically rise in value as inflation rises. With the full trust and credit of the United States backing them, all Treasury bonds are automatically safe (in terms of interest payments), but TIPS also guarantee that the value of your investment will remain unaffected by inflation. In one small package, you protect yourself against financial loss and loss of purchasing power.But there is a drawback to this, whenever the value of your TIPS bond increases due to inflation, the Internal Revenue Service considers this increase as a taxable income.

TIPS is treated as a gain—even though it's purely a gain on paper (except that you didn't sell the bond at the new higher price). Why does the IRS think this is true? The intelligent investor should remember the wise words of financial analyst Mark Schweber, "Never ask a bureaucrat 'why'?" Because of this vexing tax complication, TIPS are best suited for tax-exempt retirement accounts, such as IRAs, Keoghs, or 401(k), in which your taxable income doesn't increase.You can buy TIPS directly from the U.S. government at www.publicdebt.treas.gov/offofiatlin.htm, or you can buy them from low-cost mutual funds like Vanguard Inflation Protected Securities or the Fidelity Inflation-Protected Bond Fund. Whether bought directly or through a fund, TIPS are an ideal alternative to a proportion of your retirement funds that you would otherwise hold in cash. Don't trade them: TIPS can be volatile in the short term, so they work best as permanent, lifetime holdings. For most investors, allocating at least 10% of their retirement assets to TIPS is a wise way to keep a portion of your wealth completely safe and away from the long, invisible fingernails of inflation.

Important:

1.The U.S. Bureau of Labor Statistics, which calculates the Consumer Price Index (CPI) that measures inflation, maintains a detailed and comprehensive website: https://www.studyiq52.blog-.For a lively discussion of the 'inflation is dead' scenario, see https://www.studyiq52.blog/2025/07/comment-on-chapter-2.html. In 1996, the government appointed the Choskin Commission, a group of economists, to examine the accuracy of the official rate of inflation. The estimate, or inflation rate, was overstated. Often inflation was overstated by two percentage points each year. For the commission's report, see https://www.studyiq52.blog. Many investment experts now feel that stagflation, or falling prices, is more dangerous than inflation. The best way to limit this risk is to include bonds as a permanent component in your portfolio. (See chapter notes)

2.'For more on this practical pitfall, see 'The Mummy Etuation' by Eldar Shaffir, Peter Diamond, and Amos Twersky, in Choices, Values and Frames, edited by Daniel Kahneman and Szabo Twersky (Cambridge University Press, 2000), pp. 335-355.

3.'That year President Jimmy Carter delivered his famous 'Malage' speech, in which he warned of a 'crisis of confidence' that 'attacks the heart and soul of our national will', and which 'threatens to destroy the social and political fabric of America.'Stanley Fischer, Ratna Sahai and Carlos A. Wesch, 'Modern Hyper and High Inflation,' National Bureau of Economic Research, Working Paper 89301, at https://www.studyiq52.blog* The United States actually went through two periods of hyperinflation. During the American Civil War, from 1777 to 1779, prices nearly tripled each year. During the Civil War, a pound of butter in Massachusetts cost $12 and flour reached $1,600 a barrel. During the Civil War, inflation jumped to annual rates of 29 percent (in the North) and nearly 200 percent (in the Confederacy). Until about 1946, the inflation rate in the United States was 18.1 percent."I am indebted to the critical but accurate insights of Laurence Siegel of the Ford Foundation. Conversely, in times of deflation (or persistently falling prices) it is more profitable to be a lender than to be a borrower. This is why most investors should hold at least a portion of their assets in bonds, which can act as insurance against falling prices.

4.When inflation is negative, it is technically called 'deflation'. Falling prices sounds good at first, until you think of the Japanese example. Prices in Japan have been falling since 1999. The value of real estate and the stock market have been falling year after year. This is certainly nothing short of a constant torture for the world's second largest economy.'Ibbotson, Associates, Stocks, Bonds, Bills, Red Inflation, The Book, (Drottson Associates Chicago, 2003), table 2-5. The same pattern appears outside the United States, for example in Belgium, Italy, and Germany, where inflation was particularly high in the twentieth century. Elroy Dimson, Paul Marsh, and Mike Staunton explain that inflation appears to have a negative effect on both stock and bond markets. See Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002), p. 53.