Updated on 10.17.08

The Intelligent Investor: The Investor and Inflation

Trent Hamm

intelligentThis is the third in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the second chapter, which is on pages 47 to 57, and the Jason Zweig commentary, on pages 58 to 64.


It’s a word I’ve never liked. It represents an erosion in everything we work hard for. It naturally devalues our investments, working against growth. It causes items on the grocery store shelves to inch up in price, completely out of our control.

When my father was a boy, he would go to the gas station and fill up tanks of gas for his boat motor. The cost? Sixteen cents a gallon. Right now, I can buy a gallon for about $2.70 – that’s a sixteenfold increase. Over those sixty years, the price of a gallon of gas doubled, doubled again, doubled again, and doubled yet again.

In other words, the value of a 1940s dollar is roughly sixteen times the value of a dollar today.

It’s inflation that makes putting dollar bills under your mattress a completely worthless investment. Even if you did nothing more with your money than put it in a savings account bearing 2% interest, you’d still be protected at least a little bit against inflation. A dollar put away in that 2% interest savings account for sixty years would be worth $3.28 – better, but still not that sixteenfold increase we’d need to keep up.

The other solution would be to just invest everything in the stock market, but if 2008 has shown us anything, the stock market is a huge roller coaster. You might be way ahead of inflation a few years, then lose most of those gains the next.

How can an investor simultaneously protect themselves against risk and at the same time keep up with (or ahead of) inflation? That’s Graham’s topic here.

Chapter 2 – The Investor and Inflation
The biggest point that Graham makes in the chapter is that there really is no true hedge against inflation. He mostly looks at stocks, pointing out that ups and downs in the stock market are largely uncorrelated with the onward march of inflation. He also looks at the history of other assets and finds much the same – gold isn’t a great long-term hedge against inflation, either.

Another point I found really interesting: Graham suggests that, for your own calculations, you assume 3% annual inflation. He made this prediction in 1972 based on historical data, so I was curious to see how it stacked up. Lo and behold, he’s not that far off. Except for a rough patch at the end of the 1970s, annual inflation rates indeed average out to right around 3% over the long haul. There are some patches that are lower, with percentages in the 2s and even the 1s, and some higher, but the average isn’t all that far off since 1972.

I think it’s fairly reasonable to use that 3% number – or 3.5%, if you want to be conservative and guess a strong inflationary rate. It’s what Graham called almost four decades ago and it’s been pretty accurate over the long haul since then.

What about investment choices? Graham’s conclusion is that diversification is key. You shouldn’t put all your money into stocks (because of the volatility risk), nor should you put everything into bonds or cash (because they usually don’t earn enough to beat inflation). Balancing these two is the right way to go. In Graham’s words:

Just because of the uncertainties of the future the investor cannot afford to put all of his funds into one basket – neither the bond basket […] nor in the stock basket, despite the prospect of continuing inflation.

Commentary on Chapter 2
Zweig does a great job of pointing out why inflation is sneaky.

There’s another reason investors overlook the importance of inflation: what psychologists call the “money illusion.” If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better that you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position – 2% worse off after inflation.

A great return is nice, but it’s not all that great if it happens during a period of high inflation. Zweig immediately points to the late 1970s and early 1980s, where you could get a CD at 11% and it still wouldn’t even keep up with inflation.

As I write this, inflation is at roughly 5 to 6%, depending on the figure you use. The CPI (a common measure of inflation) actually fell from August to September 2008, so that rate of inflation may actually be going down. In comparison, as Zweig points out, we were barely at 2% inflation from 1997 to 2002.

The point? Inflation is not constant. And it’s not something you can predict, either. Instead, it’s a constant reminder that your dollar today will be worth less than a dollar tomorrow, slowly but surely. That’s a big reason why investing is worthwhile – investing helps your dollars keep pace with that growth, usually ahead of it, sometimes behind it, but always moving against that force.

One avenue that Zweig explores as a hedge against inflation are TIPS – treasury inflation-protected securities. These increase in value directly with inflation – if inflation is high, these return well. However, Zweig encourages you only to buy them in retirement accounts where you won’t be whacked with a tax penalty, because the taxation on TIPS can keep you on your toes otherwise.

Next Friday, we’ll look at Chapter 3: A Century of Stock-Market History: The Level of Stock Prices in Early 1972.

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  1. Real Estate has often been viewed as a hedge against inflation. The latest “crash” aside, I believe that owning a home or land is one of the best “hedges” one can have aginst inflation.

    Outside of owning an oil well, or mineral rights on land where oil has been drilled, stocks in energy companies are likely your next best bet in hedging against oil/gasoline prices.

  2. Nick says:

    “it’s a constant reminder that your dollar today will be worth less than a dollar tomorrow, slowly but surely.”

    Trent: Isn’t this reversed? If I have a dollar in 1940, it is worth significantly more than a dollar in 2000. It’s always better to have money today rather than tomorrow for this reason correct?

    Your statement above indicates that if I offered you a dollar today or a dollar tomorrow, you would take the dollar tomorrow.

  3. Johanna says:

    Paul Krugman’s story about a Capitol Hill baby-sitting co-op does a good job of explaining why inflation is economically necessary:


    The basic idea is that production has to be matched by consumption. We can’t all produce more today in the hope of consuming more tomorrow, because there would be no one to consume what we produce today and no one to produce what we consume tomorrow. There needs to be an incentive to even out the supply and demand: Consume more today, because your money won’t be worth as much tomorrow.

    So if inflation makes you too afraid to live super-frugally for 15 years and retire at age 40, then inflation is doing exactly what it’s supposed to do.

  4. ChristianPF says:

    I looked into Tips a couple years ago but didn’t buy any. Now with as many people expecting increased levels of inflation over the next couple years, it might be a good time to reconsider them.

  5. Ryan McLean says:

    Thanks for the info, I’ve never thought about it that way. So maybe I’ll make some investments, but with the market crashing in the US, its not that great of a time to invest.

  6. Ryan, if I understand things properly, now is probably a good time to invest. Aren’t you supposed to buy low?

  7. dave says:

    There is a problem with government CPI numbers, since they have change the way they calculate CPI over the years, including during the 90’s. Using a pre-Clinton era CPI formula, current CPI is at about 8-9%. That is why TIPS are a not a great hedge against inflation. Furthermore, with the trillions of dollars the government is printing these days, expect even higher inflation in the future – possibly hyperinflation.

    This is a good article on the government’s CPI number:

  8. Lurker Carl says:

    The rate of inflation is different for each household. Your actual rate depends upon the specific items you purchase, not what a government report states.

    For instance, assume Uncle Sam reported that new clothes increased 20% (across the board) in price from last year to this year. But used clothes doubled in price. For identical purchases, $1000 for new clothes now costs $1200 but $100 of used clothes is only $200. This is a dramatic increase in price, percentage-wise, but a smaller increase in actual dollars. This is how government tabulates inflation.

    Let’s assume Uncle Sam reports new automobiles increased 5% over last year. But if a particular model automobile last year was in high demand, the dealer demanded full sticker price. But if market dramatically changed this year, it is now a low demand model that is discounted 30% in order to move excess inventory. In reality, that purchase represents 30% deflation in the new car market and considerably more if that model vehicle is used.

    Self-sufficient and frugal families tend to be less affected by inflation due to their financial distance from the retail marketplace and savy buying habits.

  9. eden says:

    I would definately use an inflation rate higher than 3%. The average inflation rate of 3% is from the government’s data (I assume)- which is skewed to show a lower-than-actual rate of inflation. The offical inflation numbers do NOT include food or engergy – two things that are definately going to be rising in price – and more than 3% annually.

    (Plus if Graham is using government numbers they’ve changed the formula between now and 1972 several times so you can’t really compare the two numbers – they don’t include the same things at the same ratios.)

  10. David says:

    @Ryan and Kristin: If now is not buying time, it will be soon.

    One fact that gets lost as the pundits watch the DJIA/ S&P 500 go down is…for all pessimism (by sellers who think that the current stock price is high enough to trade it for $$$), there is a precisely equal optimism on the buy side by people who view the stock price as low enough to trade $$$ for it.

    Five or ten years from now…do you want to be the person who sold all their shares when the Dow was at 8,000; or the person who bought all their shares when the Dow as at 8,000?

    I’m buying.

  11. Mule Skinner says:

    Two thoughts:

    Stocks are down so now should be a good time to buy. The problem is that every day brings a new lower price, so yesterday’s buy looks foolish today.

    What about gold as a stable reservoir of value? And perhaps other such metals . . .

  12. Andrew says:

    Slightly off-topic but at least it’s about investing… Investment guides seem to advocate a “pick one and stick with it” sort of choice (between stocks & bonds, for instance). Changes may happen over time (more stocks when young, more bonds later on), but tend to be pretty rare.

    Now, though, I’ve got a mix of stocks and bonds in my IRA. I can change that mix online, moving money around in seconds. Does it make sense to try to “beat the market”, shifting from bonds to stocks when I expect an increase, and from stocks to bonds when I expect a decrease?

    Seems like, at worst, I’d match the short-term losses from having most of it in stocks and the short-term gains from bonds when I have most of it in stocks. At best, I’d match the short-term gains from stocks, and shelter it as bonds on the “bad days”.

    I haven’t seen any sites that recommend this. Is this just too unpredictable? or is it so obvious that nobody’s thought it worth posting about? :)

  13. Lisa says:

    Eden – it is true that they change the formula, but they change the formula to reflect what people are purchasing now. It wouldn’t make sense to include purchasing 8-tracks any more, but it would make sense to include cable tv which was previously omitted.

  14. RA says:

    Hi ,
    Thanks a lot for summarizing the content of the book.
    People like me can only read 1-2 books in investing with our crazy schedules. So we wont have time to read the good books out there or have the basics to understand meaty,technical books.


  15. Dave says:

    You really can’t use gasoline to measure inflation, as gas has risen from under $1 per gallon a decade ago to over $4 this year, but dollars are certainly not worth 1/4 as much.
    It’s also worth mentioning that with oil dropping like a rock and the country heading into recession, we might be looking at DEFLATION in the near future.

  16. Troy says:


    “It’s a word I’ve never liked. It represents an erosion in everything we work hard for. It naturally devalues our investments, working against growth.”

    Inflation is a natural by-product of growth and hard work. Inflation is caused by hard work, innovation, improvements, advancements in science, technology, service, etc.

    While it is true inflation devalues todays dollars, it also guarantees more of tomorrows dollars for it’s offset.

    While it is true that the cost of that gas when you were a kid has doubled and doubled and doubled, so have incomes. It is because that gas price rose sixteenfold that socital advancements that were not even available then are commonplace now.

    Without inflation, there would be no innovation, no research, no advancement, because the underlying reason for those advancements is more profit. Profit equals inflation.

    Inflation is not the problem. Not controlling or outpacing it is.

    The erosion you are talking about – Deflation.

  17. Lurker Carl says:

    Government inflation numbers purposely take energy, housing and food costs out of their calculations. These commodities used to be included until inflation numbers were tied to determine annual COLA for various government programs. When those three commodities are not part of the calculation, inflation numbers are much lower on average as is the cost of programs tied to inflation.

  18. dave says:


    I think you may have it backwards. Deflation is not erosion. It means you can buy more goods with your savings. It is good for savers. Also, you get deflation with productivity increases because we become able to produce things with less cost. During the industrial revolution, prices decreased, which was good for consumers and world progress.

    Inflation means your dollars are worth less because of an increase in the money supply. This only helps debtors because their loans become easier to pay as they are worth less over time. For instance, when the U.S. was on the gold standard, there was a group of farmers and other debtors who wanted to switch to a silver standard because it was more plentiful and was being produced at a higher output, thus there would be a greater increase in money supply and more inflation – making their debts easier to pay. Inflation is due to the growth in the money supply, which is currently controlled by the government.

    Just some thoughts…

  19. Roger says:

    With respect, Trent and dave, I think Troy’s got it right; while inflation is troublesome (and can be dangerous, if not controlled and managed) deflation is worse. First, consider the case of savers. Deflation causes a problem because it makes the ‘mattress solution’ of simply holding onto your money much more attractive. While increased savings are good for you, it leads to less money being injected back into the economy, either through investments or spending.

    In the extreme case, someone in an environment of deflation could simply build up and live off their savings (which would be steadily increasing in real value). While that’d be a pretty sweet deal for the person in question, it deals the economy as a whole a double-whammy: neither the saver nor his money is working, and the goods and services the rest of us have to enjoy are decreased as a result.

    Second, while debt and debtors have gotten a bad rap lately (not without reason), there are legitimate reasons to take on debt. Consider mortgages, for example; people are willing to take on debt that will require decades to pay off, in order to use that money to buy something that will increase in value over the years. But lately, house prices have been deflating as a result of the bubble bursting; the result is that many people are finding themselves in situations where their house is worth than they spent (or owe). New houses aren’t being built and many would-be homeowners are only considering buying now with the expectation that house prices will start rising again eventually.

    Now, imagine this current housing situation wasn’t caused by an overinflated bubble bursting; what if housing prices DECREASED by 5% a year in the regular course of events? Who in their right mind would take out a thirty-year mortgage for a house that’d be worth half the starting value in fifteen years, and one-quarter the value in thirty? As a result, we have a situation where there is an incentive for people to avoid buying non-liquid assets, since they’re going to be worth less in the future than the amount of money needed to acquire them. Similarly, this deflation would cause companies to spend less money producing goods and providing services; it’d be harder for them to get a return on their money that made up for the risk of losing money running their business. And any loans they’d take out would have to be paid back with more expensive future dollars, adding a further burden on their sales.

    Both of these situations lead to our third problem, the risk of a deflationary spiral. As noted by Wikipedia (http://en.wikipedia.org/wiki/Deflationary_spiral), what happens in such a spiral is that (a) declining prices lead to decreased demand (why buy it now when it’ll be cheaper next month?), (b) lower demand causes lower production (no need to produce as much if people aren’t consuming), (c) lower production leads to higher unemployment (fewer people are needed to make the goods that are actually consumed) and lower wages (unemployment increases competition for jobs, and people are willing to accept less for the same work since the deflated money stretches farther), and (d) less money coming in for consumers exacerbates the demand problem in part (a), dropping demand even further and starting the cycle again.

    Don’t get me wrong, neither inflation nor deflation is wonderful. Inflation decreases the purchasing power of money, forcing you to take additional risks in order to offset the decline in the real value of your savings. Deflation leads to a decline in productivity and an increase in unemployment. Given those options, I’d take mild or moderate inflation any day, and simply invest my money in a way that provides a return above and beyond the rate of inflation, as Graham is describing.

  20. Ethan Bloch says:

    @Nick A better phrasing of this sentence would be: “a dollar’s worth of milk today will be more then a dollars worth of milk tomorrow” or better yet “a dollar today will buy less than a dollar tomorrow”. It’s not really about worth however buy about purchasing power, inflation erodes purchasing power so a dollar will buy less tomorrow then today.

    Your are getting the concept of inflation mixed up with the time/value of money.

    Hope that helps.



  21. Ethan Bloch says:

    @Dave Some of what you say I am in agreement with, however saying deflation is good is a dangerous statement. Deflation is an economies worse nightmare because a countries central bank can only set interest rates as low as 0%.

    In this sense a central bank can actively fight inflation because they can rise interest as high as the see fit, but is left weaponless against deflation. To understand how terrorizing deflation can be just study Japan’s economy during the 1990’s and 2000’s.

    The worst thing about deflation is that people stop spending money because they anticipate a drop in the price of goods and services and when people stop spending money… well you get the idea.

    Finally, inflation isn’t just caused by loose monetary policy, but is caused by a tight supply of goods and services.

    Inflation in oil prices anyone? Commodities prices? This isn’t due to loose monetary policy but tight supply. Which translates into a certain amount of money chasing to a limited supply of goods.

    The reason monetary policy can also create inflation is because it can cause too much money to chase to few goods.

    This is why during times of inflation in helps to raise interest rates, which in turns reigns in the amount of money chasing the limited supply of goods.

    Anyone can feel free to email me if they wanna take this chat offline.



  22. Ethan Bloch says:

    @Lurker Cal Energy, housing and food prices may be taken out of the governments inflation numbers, but none-the-less are VERY REAL COSTS to you, me and everyone else; and should never be overlooked.

  23. Mule Skinner says:

    Troy: Inflation is ok if your income keeps up. But I had the experience of an employer saying that they only gave merit increases, not cost of living increases. So if your productivity only stayed level you would fall behind in buying power. If your productivity increased you might get ahead or maybe just keep up, albeit with the illusion of getting ahead.

    Dave: deflation is great if you have cash in the bank or no decrease in income.

  24. Trent, I don’t want to get hung up on the intimate details of inflation vs. deflation. The purpose of the of your review is to help us understand Graham’s concepts and integrate them into our own investment strategies. I don’t know if we will ever get another buying opportunity as good as this one when there is so much fear and hysteria.

    For myself, I continue purchasing shares of leveraged ETF’s with each massive hit on the market. Members of Congress, government advisors, banking officers, and investment analysts all have 401(K) plans that are taking big hits. Trust me, they are not going to allow the market to take their underwear. Things will get corrected and the people buying at the bottom will really be rewarded.

  25. Dave says:

    Guys, deflation is not great because consumer spending comes to a halt.

  26. Nick says:

    Battling inflation is just another thing you have to deal with when investing. There is nothing you can do about it. Investors have been dealing with it forever though, and it isn’t insurmountable. You just need to come out far enough ahead that you cover yourself and that inflation.

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