Thursday, September 15, 2011

People just don't understand inflation.

A recent article on Yahoo Finance talks about "Hedging 7 Big Retirement Risks"

The article is OK overall, but demonstrates a serious misunderstanding of the effect of inflation on stock prices (something that I am particularly interested in).  The offending paragraph states that:

To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich
 It is incorrect that growth stocks (low dividend paying high P/E stocks) will be a better inflation hedge than dividend paying stocks.   The value of both stocks derives from the present value of the cash flows generated by the underlying business.   Growth stocks reinvest this cash flow, income stocks tend to pay it out.  Either way, on average, the cash flow will grow at the rate inflation.  Thus the expected return on both types of stock is directly correlated to the expected inflation in the economy.  They are both "real" assets and should provide a hedge against inflation.