Question

When discussing stock and bond return determinants, Malkiel notes that inflation is deadly for bond investors but not stock investors. Which factors determine bond returns and why does inflation have such a large effect on those returns? equities are meant to provide an inflation hedge. How does the hedge work? Does it always work?

Answer 1

As bonds have fixed returns, suppose the duration of a bond is 10 years and coupon rate of bond is 4%. Let's say the inflation of that economy is 5%, the bond is giving you some return but it is unable to beat the inflation. The $100 invested a year ago would have become $104 but according to inflation, the goods costing $100 a year ago would have become $105, costlier than your investment.

On the other hand, when you invest in equity, you are investing in shares of companies. When inflation goes up, goods are getting costly, and are in turn increasing the revenue of the company, which in turn increases the net profit and then the share price of the company and the chain goes on. Thus, the inflation risk is getting covered, which is called being hedged from inflation.

Your last question is does it always work, so the answer is NO. Nothing is sure in equity market. Everything depends upon the demand and supply. But if you stay diversified and choose good quality stocks, your portfolio is definitely going to beat inflation.