Stocks are scary to own, but they are your best inflation fighters

Individual investors have fled the stock market in droves ever since the great bear market of 2008. The latest statistics show investors selling more stock mutual funds than they buy and putting much of the proceeds into bond funds. Meanwhile market volatility has increased again as another round of scary financial headlines from Europe have pushed prices down sharply in recent weeks.

Investment sentiment indicates investors are willing to accept very low interest rates on bond investments because they are more concerned about the return of their money than the return on their money. This may be a big mistake for those planning to use their investments to fund a lengthy retirement. Despite slow economic growth, and even some contraction around the world in recent years, inflation remains an ever-present threat. The most recent government reading gauged inflation at a 2.3 percent annual rate. While that is below the long term average of about 3.5 percent, it still poses a problem for investors who are hiding in fixed income investments. Currently bank deposits, money market mutual funds, and short-term U.S. Treasury bills are paying virtually nothing. Investors willing to risk locking in a rate for 10 years on a U.S. Treasury will get only 1.79 percent. That would mean a loss in real purchasing power—after taxes the interest paid on the 10-year investment would be less than the current rate of inflation.

Stocks, of course, have not been generating any great returns lately either, but they have the potential for total returns going forward that will beat inflation, while bonds are likely to be losers (except in the case of a new Great Depression accompanied by massive disinflation). Since World War II, investors have been used to getting returns of 4 or 5 percentage points above inflation on stocks. Although forecasters say those days may be over for a while, they say that diversified investors still should be able to manage 2 to 3 percentage points above inflation in the stock market. It may also feel painful as you wait for those returns—there will be plenty of short-term periods when stocks lose value and the markets look scary. But the only rational response is to stick with a diversified portfolio and try not to react to the market’s ups and downs. Statistics kept by research firm Dalbar consistently find that mutual fund buyers who buy and sell rather than staying invested all the time routinely make timing mistakes and end up getting much lower returns than they would have if they just stayed invested. 

An investor who bought an index of big American stocks at the beginning of this century has had a return of less than 2 percent per year. But a more diversified portfolio that includes a mix of big and small stocks, international and domestic stocks, domestic and international bonds, and commercial real estate trusts has done better. A balanced index with 60 percent in stocks and 40 percent in bonds has returned 6.5 percent per year since January 2000, says Dimensional Fund Advisors.