When inventor Alfred Nobel died in 1896, he created a foundation to reward cultural and scientific achievement. The Foundation’s first award of 150,000 Swedish kronor occurred in 1901. Over the years, the prize remained around 150,000 kronor, but by 1950 the amount of goods and services the award could purchase had fallen 69%. Guided by Nobel’s instruction that the endowment be invested in “safe securities,” it became obvious to the Foundation’s trustees that bonds and mortgages (“safe securities”) were not generating sufficient returns to grow the endowment or even match inflation. In the early 1950s, the Foundation gained permission to invest in stocks and real estate, which it did. Today, the endowment is worth more than twice Nobel’s initial stake in real (after-inflation) terms, and the payout per award has grown to about $1.5 million.
We have often made the case for stocks as long-term investments (and I suspect we will continue to do so), and the Nobel Foundation’s experience is an excellent case study in the importance of real, after-inflation returns. Investors concerned with such returns should consider an important difference between stocks and bonds. In the 5th edition of his book, Stocks for the Long Run, Wharton finance professor Jeremy Siegel documented 30-year real returns for both stocks and bonds under various levels of inflation from 1871-2012. Real annual stock returns were consistently in the 6.2-7.1% range, while real bond returns were as high as about 6% during periods of very low inflation and were under 2% during periods of high inflation. Put differently, stocks are a bet on future economic growth, while bonds are a bet not only on the issuer’s creditworthiness but also on the future erosion of purchasing power by inflation.
The reason real stock returns are not sensitive to inflation is because stocks represent a claim on real assets, such as factories, equipment and human capital, that are used to produce goods and services. Over long periods of time, the value of both the assets and their output tends to incorporate inflation into their pricing. If prices rise, so does the value of their output. Bonds, however, represent the promise of fixed future cash payments. Rising inflation will clearly reduce the purchasing power of those payments over time; the higher the inflation, the greater the reduction. Some bonds, such as Treasury Inflation Protected Securities (TIPS), do offer buyers some protection, though it comes at a price, with real yields on 30-year TIPS currently less than 1%.
At just over 2%, current U.S. inflation may be fairly low by historical standards, but even such low levels compounded over time will inexorably cut purchasing power. Further, there is no guarantee that inflation will remain low. Either way, unlike investors who limit themselves to so-called “safe” financial assets, stock investors can expect real returns to be largely unaffected by the inflationary environment over the long term.