When Inflation Has Outpaced Both Stocks and Bonds

Confidence about having enough money to live comfortably throughout retirement fell nine percentage points to 64% in the latest Retirement Confidence Survey. The last time a drop of this magnitude occurred was in 2008.

Inflation was a big contributor to the drop in confidence. According to the Employee Benefit Research Institute (EBRI), 29% of workers and 42% of retirees cited inflation as “the reason for their lack of confidence.” This isn’t surprising given last year’s jump in prices and the drops both stocks and bonds incurred.

While inflation makes for a good song, it erodes our purchasing power—meaning our ability to buy goods and services with the dollars we have. A dollar today certainly doesn’t buy as much as it did just a few years ago as you well know. This is why we need our long-term savings to grow faster than the rate of inflation.

Equities have historically been the best inflation fighters. Large-cap stocks have realized an annualized return of 10.1% between 1926 and 2022. The 2023 Ibbotson “Stocks, Bonds, Bills, and Inflation” (SBBI) Yearbook shows small-cap stocks performing even better, with an annualized return of 11.8%.

Bonds have fared decently against inflation. Long-term and intermediate-term bonds have returned 5.2% and 4.9%, respectively, on an annualized basis between 1926 and 2022. Inflation, meanwhile, has risen at an annualized rate of 2.9% over the same period.

There have been some years when inflation was higher than the returns of both stocks and bonds—eight specifically since 1926. Last year was one of those eight. The SBBI Yearbook lists inflation as having risen by 6.45% in 2022. Out of the aforementioned investment options, intermediate-term government bonds fared best in 2022, with a decline of 9.36%.

The other seven years were 1937, 1941, 1946, 1947, 1973, 1974 and 2018. Two of those years, 1937 and 2018, had average-to-low levels of inflation (3.10% and 1.91%, respectively) but negative returns for stocks (especially 1937) and lackluster returns for bonds (particularly in 2018 when the Federal Reserve reduced its balance sheet). Inflation jumped in 1941 to 9.72% as the U.S. economy was emerging from the Great Depression and the U.S. became entangled in World War II. The lifting of price controls, supply shocks and the post-war jump in demand led to the high inflation of 1946 and 1947 (18.16% and 9.01%, respectively). An increase in food prices, the oil embargo and the end of wage-price controls sent prices flying in 1973 and 1974 (inflation of 8.80% and 12.20%, respectively). We certainly saw the impact of supply chain problems and the transition to post-pandemic lifestyles on prices in 2022 (inflation of 6.45%).

Having eight years with inflation higher than the returns on stocks and bonds also means that there were 89 years out of the last 97 years when either stocks or bonds fared better than inflation. Both stocks and bonds beat inflation during 24 of those of years. While this is not a guarantee of what will happen in the future, the historical data does provide favorable odds for using a diversified portfolio to fend off the eroding impacts of inflation.

As far as dealing with inflation, the two additional base strategies depend on whether you are in the accumulation (saving) stage or the withdrawal stage.

Those who have long investing time horizons should consider using allocation approaches that are mostly (or entirely) focused on equities. Stocks have the best odds of beating inflation due to their higher returns and greater frequency of having the best annual gains. If you can, saving more will also help. (Saving more also works in a low-inflation environment.)

Retirees and others who are taking withdrawals should be aware that withdrawal strategies like the 4% rule tend to fail when inflation is high. Such strategies also struggle when bear markets occur during approximately the first 10 years of retirement. Maintaining some allocation to cash (to avoid selling stocks in down markets), being able to cut back on your spending (or at least not increase it) and taking a flexible approach to how much you withdraw can help significantly.