Monday, June 10, 2019

Why stocks are good hedges for inflation.

I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.
Article is here: https://www.wsj.com/articles/which-is-the-better-inflation-hedge-stocks-or-gold-11560132361?mod=searchresults&page=1&pos=8

Quoting from the article:
The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.
To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.
Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.
Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."

Thursday, January 17, 2019

Bogle and the genius of indexing.

Jack Bogle passed away this week and the investing world lost one of the most important figures in modern history.   Bogle's contribution to investing is simple but of profound importance.  He showed that an index fund, run entirely passively, could outperform most actively managed funds in the long run. 

I've long been a very strong proponent of indexing.  I've posted heavily on the topic here in this blog, but a quick recap of why indexing is so brilliant is probably in order.

In any given year (ignoring costs), about 50% of all active equity managers will beat the market, while 50% or so will trail the market.   This has to be the case.  It cannot be the case that the majority of equity managers beat the market, because the market is largely actively managed.  Simply put - there has to be winners and losers. 

In reality however, more than 50% of active managers trail the market because of trading costs and fees.  These costs can easily be 1-3% or more per year, enough to cause a significant drag on performance.  Bogle realized that if you just bought "the market" and didn't trade and didn't spend money on active management, you could reduce the total costs to a nearly trivial amount, less that 1/10 of a percent.   The simple outcome of this strategy is that the "indexed" fund will beat more than 50% of all active funds in a given year, and in the long run will beat most active funds.

You might be thinking, surely 1 or 2 percent isn't that much?   Well, consider an investor with a million dollars: 1% is $10,000 per year every year.  This is a significant performance drag.

Or consider if you take $1,000 and compound for 40 years at 8% you'll end up with about $21,724.  But if you compound only at 7%, just 1% less per year, your original $1,000 will only grow to $14,974.   The 8% investment is worth 45% more than the 7% investment. 

This is why, in the long run, indexing always wins.  It's why I personally am 97% indexed and why I strongly advocate it for all investors (including pension funds).

And this is Bogle's legacy.  He's enabled many ordinary investors to be much wealthier than they would have bee had they stuck with active managers.

As Mark Hulbert says:
"... he bet his entire career and his mutual-fund firm on the notion that the vast majority of active fund managers would be unable to beat a simple index fund. And there was hardly a single calendar year since 1976, when he created the Vanguard 500 Index Fund in which he was wrong."