Morningstar - Q4 2020 - 13

to commodities, and 3) swapping high-growth
stocks for value stocks. (Inflation hurts growth
stocks more than their cheaper rivals because the
cash flows that accrue to growth companies
tend to occur further in the future. That is, growth
stocks have longer durations.)
I do not necessarily advocate these transactions.
Doing so would overstate my confidence that
inflation will indeed resurface. (To paraphrase
Warren Buffett, when a highly credible investment
source-such as Bill Bernstein-attempts the
perilous task of predicting macroeconomic events,
it is usually the reputation for peril that remains
intact.) However, they are worth considering,
particularly if the trades align with other reasons
for adjusting one's portfolio.
Currency Versus Cash
When I first made this proposal in an August
Morningstar.com column, a few readers
questioned my claim that cash would be a useful
asset should inflation resurface. Let's discuss.

To start, the standard depiction of cash as an
asset that withers over time is false. The
motivational speaker holds up a 3-cent stamp and
proclaims, "This is what happens to people
who don't invest." (I watched that very
presentation.) Not so, unless the cash consists of
currency stashed under a mattress, thereby
becoming a foolish version of gold that burns
all too easily.
Cash as an investment-meaning cash that is
held in an account-behaves differently.
It appreciates in nominal terms because of
compounding. If placed into one-month Treasury
bills and reinvested, three 1933 dollars would
now be worth $54. What once could purchase 100
first-class stamps currently buys 98 stamps.
Roughly speaking, reinvested cash preserves
purchasing power.
(Note: Properly speaking, cash has a very short
life span: at most one year, and likelier only
a few months. People often call long-term bank
CDs "cash," but if the investment is for three
or five years, the term is inaccurate. Such
certificates are the equivalent of intermediateterm bonds.)

The reason to hold riskier assets is not to protect
against the damage caused by inflation,
because reinvested cash does that, but instead
to grow one's wealth. That is a reasonable
goal, for which cash is ill-suited. Under
normal circumstances, cash hampers portfolios.
To reiterate, the problem is not that cash
tends to lose value in real terms but rather that it
doesn't increase an investor's net worth. For the
most part it sits there, treading water.

The 1960s: Inflation Begins From
January 1966 through December 1972,
inflation averaged 4.2%.
Annualized Real Return (%)

Cash

0.9

Intermediate-Term Bonds

1.4

Long-Term Bonds

-1.6

Large-Cap Stocks

2.6

Source: Morningstar Direct.

History's Guide
There are, however, times when going nowhere
is relatively attractive because other investments
are heading south. One such occasion,
obviously, is during a recessionary panic. Nobody
doubted cash's value during the Great
Depression or during the 2008 global financial
crisis. Losing nothing was far better
than the alternative. Does the same hold true
when the threat is inflation as opposed
to deflation?

Cash was useful but not necessary. It outperformed
long bonds, which were depressed by the
prospect of spending many years making the same
fixed payments, even as inflation abraded those
future values. However, cash slightly trailed
intermediate-term bonds and fell further behind
stocks. All except the most risk-averse of investors
would have been happier holding a balanced fund.
Then the problem became real.

The query is difficult to answer, as the post-World
War II sample size is effectively 1. Inflation in
the United States was dormant from 1948 through
the mid-1960s, then rose sharply until 1981,
then began a long decline. (The pattern was very
similar in the United Kingdom and moderately
so in Japan and Germany.) There just aren't very
many data points to analyze.
We can, at least, divide that inflationary period
into two parts. The first is the introduction,
when price increases initially appeared. The
second is the main event, when inflation raged
so fiercely that onlookers feared it would
never be tamed. The introduction ran from 1966
through 1972, featuring an average annual
inflation rate of 4.2%. The main event followed
from 1973 through 1981, with the annual inflation
rate averaging a debilitating 9.2%.
By the Numbers
Here are the returns, after inflation, for four
U.S. assets during the first period, as measured
by Ibbotson's database (which is owned by
Morningstar). The assets are: 1) cash, represented
by one-month Treasury bills; 2) intermediate-term
notes; 3) long-term bonds; and 4) large-company
U.S. stocks. All figures assume reinvestment.

The 1970s: Inflation Rages From
January 1973 through December 1981,
inflation averaged 9.2%.
Annualized Real Return (%)

Cash

-1.0

Intermediate-Term Bonds

-3.4

Long-Term Bonds

-6.9

Large-Cap Stocks

-4.4

Source: Morningstar Direct.

Ouch! Those performances were bad. Annualizing
the returns disguises the destruction. When
calculated as cumulative results, that 6.9% annual
long-bond decline translates into 52 cents
on the dollar. Talk about losing purchasing power!
Large stocks shed one third of their worth
(although curiously, small stocks fared well-
perhaps that's a topic for another column), and
intermediate bonds fell by more than one fourth.
Only cash came close to retaining its value.
That outcome was the basis for my defense of
cash as an inflation hedge. Only once in the

morningstar.com/lp/magazine

13


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Morningstar - Q4 2020

Table of Contents for the Digital Edition of Morningstar - Q4 2020

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Morningstar - Q4 2020 - CT1
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Morningstar - Q4 2020 - Cover1
Morningstar - Q4 2020 - Cover2
Morningstar - Q4 2020 - 1
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Morningstar - Q4 2020 - Contents
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