In today’s inflationary environment, several people have made the remark to me along the lines of “it’s dumb to sit on cash”, “or I’m losing wealth if I’m not investing due to inflation.” I do not agree with the premise.
Let’s take a step back into what cash/money is. Money is 3 parts:
- Unit of measure
- Medium of exchange
- Store of value
Inflation erodes the last part, the “Store of value”. Keep in mind, a dollar is still a dollar, a euro is still a euro, so the unit of measure if unchanged. However what you can exchange for that dollar/euro is what is changed.
Functionally then, the basis that inflation erodes the worth of cash is fundamentally true. However, what one must remember is that investments that are denominated in the same unit of measure also erodes as well. The relative difference is generally unchanged.
Let’s assume the inflation rate of 7%. Let’s assume you make an investment that is expected to return a nominal rate of 10% annualized. If you sit on cash, your value erodes 7%. If you invest, then your value still also erodes 7%, resulting in a real rate of 3% annualized. Because your investment is ultimately denominated in the same currency as your cash, it is proportional to one another. It’s all relative. Hence the urgency to invest should be the same whether the inflation rate is 7% or 0%. The real question is what the investment is and is it the correct investment. If it is, you would invest in it regardless of the inflation rate. The danger of the “get out of cash” mindset is rushing to invest to get out of cash and making a poor investment.
Now a rebuttal may be that when you invest, you would choose “inflation protected” investment. The concept of “inflation protected” is an investment thesis, and any thesis of investing can pay off, or it will not. I’m going to give 2 examples.
Treasury Inflation Protected Securities (TIPS). TIPS are treasuries that are adjusted to inflation and should protect against it in theory. Sounds simple enough. However, these are inherently complex instruments and further complicated that they are secondarily traded on the market. Currently the 10 year TIPS is trading at -0.61 real yield. This is because due to the demand from inflation, investors have bid up the price so that it results in a negative real yield. Even though it periodically adjusts to inflation, if you buy TIPS today, you have essentially locked in the negative real return. Keep in mind it does not mean you will lose money, since the nominal return is still positive, but rather that you may keep pace with, but will not beat inflation. Still better than cash right? Again, yes in theory…but again, these are traded on the open market. Assume next year, inflation calms down. Demand for TIPS drops, and price drops. If you invested into TIPS, and you decide to sell, you will lose on your principle. If you don’t decide to sell, again you locked in a negative real yield over the 10 year term. The converse is true, if inflation runs hotter than expected over the next 10 years, then this would be a profitable investment.
Real estate. I keep hearing the cliche of buying real estate to keep pace with inflation. Again, let’s break it down. Suppose you buy a duplex to rent out. Inflation is usually measured in terms of goods and services. Whether or not goods or services prices go up due to inflation has no direct effect on your real estate. The expectation however is that wage inflation also occurs. So rise of goods and services, causes rise of wages, which means you can charge more rent to your renters. This sounds good in theory. However, multiple separate economic factors come into play. For example, due to various economic forces, whether it’s the historically low interest rate or the demand of real estate, the asset price of real estate is driven higher, causing you to buy higher and decrease your expected return. Also, the economy and labor markets can stall despite inflation (stagflation), so that your renters are not able to keep pace with what you want to charge for rent.
My point in highlighting these complexities is not to suggest whether or not to invest in TIPS or real estate. But rather the concept of “inflation protected” investment is still inherently a thesis that needs to play out, and may play out for or against you. Which is why at the end of the day, sitting on cash while carefully evaluating investments and awaiting opportunities is not a bad thing. I would caution rushing to invest due to inflation.
(In this perspective, I am specifically ignoring the dystopian view of the dollar spiraling into hyperinflation causing a return to sound money.)
