How Investors Can Hedge Against Inflation

Morgan Housel is the best-selling author of The Psychology of Money.

He recently joined Motley Fool co-founder and CEO Tom Gardner for a conversation about:

• Why cash is a better hedge against inflation than many believe.
• Parallels between the 2022 stock market and the dot-com bust of the early 2000s.
• What Tesla investors can learn from Starbucks' past decline.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 8, 2023.

Morgan Housel: Everyone thinks when there's high inflation, you don't want to own cash. Your cash in your savings account, your checking account, is losing value to inflation, and you want to get rid of that. You want real assets, real gold and whatnot. But whenever inflation pops up and it's unexpected, everything gets demolished. Crypto gets demolished, bonds get demolished, stocks get demolished, gold gets demolished -- every single time. That's what happened in 2022, happened in the 1980s, happened in the 1970s -- short term, everything gets wiped out. The smallest declines, so to speak, come from cash.

...

Chris Hill: I'm Chris Hill, and that's best-selling author Morgan Housel. He joined Motley Fool co-founder and CEO Tom Gardner a few days ago at our member event, and we're bringing you part of that conversation. Tom and Morgan discuss how investors can hedge against inflation for the short term and the long term, and some unexpected parallels between Tesla and Starbucks.

...

Tom Gardner: It's been such a painful time for growth investors, but the long-term prospects still remain very bright, in my opinion, for so many of these companies -- certainly not all of them. We'll be talking about that, but we want to start at the macro level and talk about the primary worries that investors face. So Morgan, why don't you start this off.

Morgan Housel: I think one big worry that virtually everyone has right now that is not ... I'm not saying it's wrong, but I think there's a pretty easy pushback to it. I think people are taking this worry to extremes that they shouldn't, which is the idea that what has happened in the last 12 months or so is somehow abnormal, or somehow indicates that the market is broken, or that there's a big fundamental flaw, or that you as an investor, necessarily made a mistake, so to speak. In some cases, that might be the case. There might be things that people regretted. But I think if you look historically, in my view, there is virtually nothing that has happened in the last 12 months that I would consider abnormal or unprecedented or something that even I would not say is guaranteed to happen over the course of your life as an investor.

There's a great quote that I love from a writer named Kelly McGonigal, who says, "Everything feels unprecedented when you haven't engaged with history." Such a good, good quote. I think in times like these, in the last 12 months, is when being an amateur market historian is the most advantageous. Everything from the Nasdaq going down 30-some-odd percent to plenty of companies going down 60%, 70% or more, to companies like FTX being exposed as a fraud -- if we can use that word now. I don't want to discount the pain and the anxiety and the uncertainty that that can cause. But none of that is unprecedented, and all of that is a guaranteed feature of being a long-term investor.

I do think there is a point to make here that if you were to look at the last five years and ask the question,  "What is the anomaly of the last five years?", It's not the decline that we've had over the last 12 months. I think the anomaly over the last five years is the boom that occurred in 2021 during the biggest economic upheaval of the last 100 years -- which is not an exaggeration, coming out of COVID and all the stimulus packages -- that we got to a level of valuations that for not all companies and not as the market as a whole, but for plenty of individual names didn't make a ton of sense given where they were as companies, at least for that moment of time. If I were to look at the last five years, I think that's the anomaly. It's not the last 12 months, that's what it is.

But I think if you were to look historically at the last 100 years as an investor, even the last 30 years, as an investor, the common feature -- we talk about this so much and drive this home so often because it's so important. The common feature of all market history is volatility. When people think about volatility, it's not 5% or 10%, it's 20%, 30%, 40%, 50% volatility that tends to be more common than people think.

These aren't things that happen once in a lifetime. The 30% pullback in the Nasdaq, or 20% in the S&P [500]-- that's the kind of thing that will happen every five to 10 years as an investor. If you are an investor like Tom and I, who want to be investing for the next 30, 40, 50 years, that's the kind of thing that, it's not a possibility, I know with almost certainty that this thing is going to happen to me as an investor, I hope, five or 10 more times during my lifetime as an investor

None of that should diminish the uncertainty or the pain of watching your net worth shrivel over the last 12 months as virtually everyone has. No matter how you invest, everyone has some degree of that. I think when you view these things as an inevitability and not a signal that something is broken or a signal that you made a mistake, per se, is important. What's equally important is that if you are the investor for whom a 30%, 40%, 50% or more decline was unpalatable, you couldn't accept it, and it costs you a level of sleep that, in hindsight, looking back at the 12 months was not worth it, that's an important realization as well.

I think the mistake that people make when there is an error and where there is a scar that people will regret, it's going through a decline like this, realizing that it's too much risk than you wanted to take selling. But then coming back three years later and doing it all over again, and making that same mistake over and over again.

I think if you are the investor -- not everybody is -- but if you are the investor for whom the takeaway over the last 12 months was, "That was too much risk for me," I think that's totally fine and OK, and my plea to you would just be to embrace that mentality with both hands. And think of an asset allocation that is more appropriate for your ability to sleep at night and your risk appetite going forward.

Tom Gardner: I like that so much. Thank you for all those thoughts. They remind me of some of Peter Lynch's writings about how each time it seemed like all of the factors were new, but when you looked at them collectively over time, there were always problems, and always times of confusion, and always periods of market volatility. And Peter Lynch, I remember sharing his personal story that it seemed like every time he launched a new fund or got a new job, right as he allocated all the capital, the S&P fell 15% or 20%, and all of a sudden it was a devastating beginning for them. This market decline is most painful, most damaging for the newcomers to the markets over the last few years. And of course, that included a number of people, because we were at home, and with more time to look into the digital screens and find opportunities to invest, and that made the markets more exciting, more volatile.

And new asset classes were launched, cryptocurrency arrived, and a whole new group of investors came into the marketplace because of the conditions brought on by COVID. Unfortunately, that group is the most burned. For those of us who have invested for 10 years, 15 years, 20 years, 25 years, 30, 35 years, it doesn't mean it's not painful. I've always liked my brother David's statement that he never feels happy when the market is down. It's like, "be greedy when others are fearful and fearful when others are greedy," but he says, I never feel better when the market's down. It's not a good time. It's not a fun time as an investor, it's much more fun to see your companies being rewarded for the risks they're taking and to see your investments rise. But for those of us who've been through various cycles, we can look back and see some of the echo or hear some of the echo of the past.

So I would say for this market environment, I think it's obviously most similar to 2000, 2001, 2002, where there was an incredible boom in enthusiasm for new technologies and for things that actually have traction and are real. Remote work. As much as any company wants to think or any leader or any politician or whoever wants to think that you can mandate a return to the workplace, it's not going to happen. Because that's a daily habit formed around commutes, around taking children to school at a particular time. That daily habit doesn't come back together for everyone in an organization.

There are some organizations that are very local in their orientation, and they have a local office, and they just weren't in it and now they can all go back. But for any company that is more national or global, that has multiple offices, it can't really put everything back together the way it was before COVID.

These things are real. These changes are real and they are creating the need for new digital solutions to collaborative work communication. If we think we have Slack and Zoom, and there's still so many things that need to be discovered to help organizations, families, friends, to help people connect. And those things will be digital, and they will be cloud-native, and they will have a lot of machine learning, and there will be greater and greater efficiency that will come from it. But, of course, when we were all at home looking at the markets, that was a time of great enthusiasm. Valuations ran very high, historically. So is it unprecedented? Well, no. The patterns are there from 20 years ago. Then it can be useful to look at what happened after 2002, 2003, because everyone felt pretty shipwrecked at that point in time. I'd say probably Berkshire Hathaway didn't, and I don't think Berkshire Hathaway investors feel shipwrecked now. And S&P index fund investors don't feel as shipwrecked.

It's not such an outlier that the S&P is down 15% to 20%. It's painful. Depends who you are as an investor, but if you've been around a long time. You're more shipwrecked as a Nasdaq investor. But remembering in 2000 and 2001, the Nasdaq was down more than 70%. So here we are, we've been down by 35%, I think, 40% may be at the max, 35% at the max?

But let's look at the pattern of what happened after. And what happened after is that it turned out that the Internet was for real. You know, Pets.com notwithstanding, and a bunch of IPOs that should never have come public. And a bunch of SPACs today and a bunch of cryptocurrencies, a bunch of things that will vanish if they haven't already. And probably a few more frauds that will emerge and become more evident. But then, you will see taking hold the real R&D spend that did matter, and what those factors were. Because those companies are all being tossed to the side as well right now, pretty much indiscriminately, most growth companies right now. I mean, you could have a portfolio of Amazon and Netflix at the core. And you could feel unbelievable for the last 15 years and you feel absolutely awful for the last 12 months. It depends when you got in, but still, everyone takes this experience on in different ways. It comes in different times, different amounts of capital, different expectations. And so now, I think I really just want to affirm your basic point, Morgan, that this isn't that unique. And I say that, as painful as it has been for all of us as investors. What we can see in the past are some of the little signals, the evidence, the clues as to what could come next.

There are no guarantees in the marketplace, but we do know the market does go through cycles. And I would have to say that I think there's some wonderful technology, cloud-native companies that have some really great growth prospects over the next 10 years. I mentioned Snowflake as an example. This would be a terrible and unfortunate time to be selling the best of these companies. It's painful to have the worst of them because it's hard to avoid them for growth investors. But I think the really high-quality growth stories are very well-positioned right now for pleasing returns over the next decade.

What about inflation, Morgan? How worried are you about inflation?

Morgan Housel: Zero.

Tom Gardner: Zero?

Morgan Housel: Let me put it this way. Personally, zero. For the broader economy, maybe a four or five out of 10.

Tom Gardner: Are you worried about deflation, long term?

Morgan Housel: Long term? No. Definitely not long term, because the Fed has all the tools to prevent deflation, and it is not scared to use them. They pull out the bazookas, the howitzers, and they print trillions of dollars. Deflation, I think will virtually never be a risk during our lifetime provided we don't have a complete nut running the Fed, putting that aside.

Inflation is really interesting. In my view, I think that was the biggest economic story of 2022. It wasn't the market, it was inflation, which is, of course, at of 40-year high when we finished the year -- 8% or 9% annual inflation, it was something like that. Inflation from an investing perspective is really interesting. Everyone wants to answer the question: Hey, we have inflation, how should I invest? What should I put my money in to maintain my purchasing power?" It's a very widespread question right now, a very good question.

The answers, I think, are pretty counterintuitive. I'll give you the punchline of how I think, broadly, people should invest in inflation. Well, I should say this is not advice, because everyone is different. But here's what I think tends to work in an inflationary environment.

Let's separate short-term inflation, which is the inflation over the next 12 or 24 months, with long-term inflation, of how do you protect your capital for the next 10 or 20 years? The biggest, the most effective antidote against short-term inflation over the next 12 or 24 months is the exact opposite of what everyone thinks. What works in the short term is cash. That's what works. Everyone thinks when there's high inflation, you don't want to own cash.

Your cash in your savings account, your checking account, is losing value to inflation, so you want to get rid of that. You want real assets, real gold, and whatnot. But whenever inflation pops up and it's unexpected, everything gets demolished. Crypto gets demolished, bonds get demolished, stocks get demolished, gold gets demolished -- every single time. That's what happened in 2022, happened in the 1980s, happened in the 1970s. Short term, everything gets wiped out. The smallest decline, so to speak, comes from cash. Look at 2022. We had 9% inflation, and maybe your savings account yields 3%, so you lost 6% to inflation in your cash -- negative 6% real return is what we call that. If you look across all different assets, losing 6% in 2022 was great. That's the best that you could've possibly done -- better than crypto, better than gold, not by a little, but by an order of magnitude.

Cash tends to be how you preserve your wealth in short-term inflation. Longer-term inflation, if we're talking about more than a year or two, there, the verdict is pretty clear as well, historically. There's basically two ways to protect your assets from inflation over the long term. One is -- let's put stocks and real estate into the same bucket because that's just owning equity in real assets. What that tends to do is, in the long term, not only keep up with inflation, but tends to exceed it. The long-term inflation rate, historically, in the United States -- over the long term, the last hundred years -- on average, is 2.5% to 3%. Stocks after inflation have returned about 6.5%. So not only are you maintaining it, you're exceeding it over the long term.

That includes the 1970s, the 1980s, includes the last year, etc. Gold over the long term tends to keep up with inflation, but nothing else. And in the short term, it is a very poor inflation hedge. There's plenty of periods, even 10- and 20-year periods, when inflation was moderate to high, and gold declined. That's what happened from the mid-1980s through about the early 2000s. So in the short or even medium term, gold tends to be a pretty poor inflation hedge. And even in the long term, it's an inflation hedge, but you're not going to exceed it, you're going to maybe keep up with inflation. So as I view this for my own money and I think this is a good basic framework. How do you protect yourself from inflation? Cash and stocks.

The cash part is so counterintuitive to people, and it's almost like heretical to say that, that you want cash to fight inflation. But in the short term, I think that's the best you're going to do. It's not that you are going to beat inflation, it's just that it's going to decline the least relative to other assets, particularly something like gold or crypto that you think is going to be the best. And in the long term, it's just stocks. It's companies that can raise their prices in conjunction with inflation. When airline ticket prices go up by 50%, Delta's revenue just went up by 50%. Which will eventually transfer to the nominal dollar amount of their profits over time, which is what drives stock prices over time.

So that's how I think about inflation, in general. I would say this. I have not changed anything about my asset allocation or how I invest in years. When inflation was low in 2020 and when it was very high in 2022, I didn't make a single change to my portfolio just because, A) I just don't think it's a very wise way to be fiddling with the knobs in your portfolio based on what inflation was last month, but, B) it's that I accept that there's going to be periods of high inflation. My portfolio is not always going to keep up with it in the short term, but over the long run, I have enough cash for the short term, and I have stocks that I plan on owning for the next 30, 40, 50 years that I'm very confident will not only keep up with but exceed inflation during that period.

Tom Gardner: I really just wanted to think a little bit about what companies end up succeeding through periods like this, but not just periods like this -- just succeeding.

So if we look at Starbucks and go all the way back to their IPO in 1992, you see there, the opening price or close price in their early days, they are somewhere around 34 cents, there it is, I think something like 34 cents. So here we are, and it's $100 a share. We can look down here since the IPO and see it's up about 300 times in value, which is a very pleasing return to get over a 30-year period. Which is what it's been here for Starbucks. So 300-bagger in 30 years.

Now, a couple of things to think about. All the way through Starbucks has been steadily raising prices. I don't know what a Starbucks venti latte cost back in the early 1990s, but I can tell you it's a lot less than it does now, and they just kept inching their prices up over time because they have a brand and a unique offering in the marketplace, in large part because they're such a familiar name, and they're ubiquitous. The old joke on Starbucks was that Starbucks was thinking about opening up a Starbucks inside the men's room of existing Starbucks locations.

Now some other things to remember about Starbucks which is that its high before the meltdown was something like $18.70 there you see in October 2006, and the low in 2006, two years later, was around $4.30. So a drop from $19 to $4 -- that's about an 80% drop, 75% to 80% drop in the value of Starbucks over those years. Remember, this is a period before this, where Howard Schultz -- I think it was a mutual decision -- but kind of stepped aside from Starbucks because the feeling was that Howard had too many other interests. He wanted to acquire and create online communities. He wanted to make movies; Akeelah and the Bee. And the marketplace was saying stick to the coffee, it's a coffee business. That was part of the story.

There's a lot more dynamics that I know nothing about with Starbucks during that period, but Howard's gone, the stock falls 80%. Howard comes back and builds the business up. And I'm actually going to mention a controversial company and stock right now that I think could go through a similar journey, and that is Tesla. I think that the marketplace is getting just really disappointed in the founder of Tesla. I wouldn't say that uniformly across all people, because obviously, there are strong feelings about Tesla and about Elon Musk, and it's kind of a lightning rod. These companies like Starbucks, Apple, you can look back in history -- they all had their "lightning rod" periods, where everyone was talking about them and everyone was saying, "This is terrible, this is going to fail." And you know what? Sometimes the general marketplace was right and they did fail.

So I don't mean to say that, "Oh, this is a pattern, it's obvious and it's automatic." But to me, Tesla has a unique offering, and they have a founder/CEO, who is showing a lot of interest in other things. For me, actually, I don't mind his interest in other business. When it just starts getting so all over the place, it's too much, it's becoming a distraction, and I wouldn't be surprised if some change in leadership came or some statement or clarification on what's happening there. This is a little bit of a period that I think Tesla is going through where there are a lot of questions about leadership, and the stock is down from $400 a share to $100 a share, so a 75% decline. Now that's actually, sadly, not that unique out there on the Nasdaq among a lot of growth companies, but for such a large company, it is a dramatic decline.

But I believe that Tesla, like Starbucks -- there are very few similarities between those two business models, but powerful consumer brands with unique offerings that I believe over the long-term have pricing power -- that when these companies see their stocks decline so dramatically ... and it happens to every great growth company. We all wish that we could own, name the great company -- Amazon, Apple, Microsoft, Tesla, Starbucks -- we wish we could own them without going through a 50% decline. But that's why Warren Buffett has said if you can't handle a 50% decline in the value of one of your investments, you should not invest in it, because the probabilities are it will go through that period.

The hard thing is that all of these companies are going through that period together. That is the hard thing. The thing that's a little bit easier about is when they all go through it together, you know there are some environmental issues that are affecting all of them -- that there's not a lot of discrete individual evaluation of companies, and saying this one has fallen way behind all of the other businesses out there.

I do think the inflationary period we're going through, rising interest rates, and the attempt to return to a 2% to 3% rate of inflation annually is a big disruption in the marketplace, hurts a lot of growth-oriented companies, companies looking to reinvest in their business. And that has hurt the Nasdaq quite a bit.

So that part of inflation I can't say is underrated, but I do agree with you that I think in a long-term way, I'm much more concerned about the potential spilling over of the conflict in Ukraine than I'm about inflation.

Now, these things are all linked together, so to pull one out .. but I think that that's a much more concerning challenge than the challenge of bringing inflation back in line.

...

Morgan, we're going to close with one piece of investment advice that you offer to the world, knowing that there are so many different people in so many different situations that will hear this advice. And for some, it will be so spot on, and for others, it will be just off the bull's-eye. But what's the piece of advice that you can give that is likely to get close to the bull's-eye for as many people as possible?

Morgan Housel: I would say, if you're interested in investing and economics and where things might be going next, spend less of your time reading economic forecasts, and spend more of your time reading history. That advice probably applies to a lot more than economics. Spend more time reading history and less time reading forecasts. I think you'll have a better view and a better grasp of the future, ironically, if you do that.

Tom Gardner: I love that. For me, I'll say Shelby Davis Sr. was an investor for, really, the second half of his life. I think he really began investing in his early 40s, and I believe he died in his mid-80s. So he had about a 40-year period. Now, he did have low-interest margin access at his brokerage firm and he did use that. For those of you who already know where I'm going, I don't suggest that this is an achievable return by everyone. He was working the levers, but here is a little bit about Shelby Davis Sr.'s journey.

He started investing in his 40s, he had $50,000. His philosophy was to always be buying companies that you believe in for the long term. Obviously, to accept some of these companies went down all the way down to zero. I believe he had a company worth a couple of million dollars in his portfolio that went to zero.

Started with $50,000. Couple of million. We're talking 1940s to 1980s is the time period, that 40-year time period.

So starting at $50,000, makes his way forward, and one of his principles is, I'm never going to sell. I'll take the dividends. Some companies are acquired, I'll get cash that way. But I'm not going to sell, and that's going to cause me to work hard to try and decide what to buy. I'm pretty much not going to sell. The best time to invest is right now, and the best time to sell is never. That's Shelby Davis' barbell principles there to his investment style.

In the 1970s, inflationary period, for the stock market, the Dow Jones Industrials fell 45%, 1973-74. Shelby Davis Sr.'s portfolio was down 75%. Market was down 45%, he was down 75%. All told, from the first investment he made in the 1940s to the end of his life, he turned $50,000 into $900 million through the power of compounding, through always investing. Now again, utilized margin, low-interest margin. We really don't do that at The Motley Fool, and most people don't have access to 1% margin costs.

I haven't done the work, but if you were to remove all of the use of margin, and start at $50,000, I'll say he at least had $75 million. Let's just say that. Does anybody need more than $75 million? The key for all of us, no matter our situation, is to stretch out our time horizon and to think about creating a multi-generational wealth, where your children and their children -- even if they're not interested in investing, they don't have to be passionate about it if you are. We all know that.

I've always loved the Warren Buffett thought about succession and who should be the next CEO. I think he said something like, should John Elway's son be the next quarterback of the Denver Broncos? I don't think that's a smart way to do succession planning. But all of us can learn to use index funds, save, put money away, and let it compound over long periods of time, and allow for the really difficult years.

And I don't mean to minimize what's happened in the last year. Certainly, my portfolios that I manage at The Motley Fool and my personal portfolio are down significantly. The IPO portfolio I manage is down 60%. Most of the portfolios I manage are somewhere down 35% and 30% to 50%. Even though we're deploying cash and even though still looking at some of these companies are just seeing them, it's a painful, painful thing to go through.

But we started with Morgan asserting that it's not unprecedented. And I guess I'll close with my agreement that it's not unprecedented, as painful as it is. If it's not unprecedented there must be patterns, and there must be information that we can find to help us make smart decisions and stay in the game of investing for the rest of our lives. Morgan, thank you so much for spending this time with us, and look forward to more of these conversations together in 2023.

Morgan Housel: Thanks, Tom. It's been fun.

...

Chris Hill: As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.