"The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income taxes during years of 5 percent inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax but doesn’t seem to notice that 5 percent inflation is the economic equivalent."

Warren Buffett

My grandmother is a lovely lady. She always looked out for others, and always kept our family and her finances in order. And she would always talk about not investing in the stock market because it was a virtual casino. Her argument was it was too volatile, her house was paid off, she’d be on Medicare, she would qualify for senior discounts, she would be on Medicare, and she would have that nice social security and pension check.

Fast forward 10 years later…

She is having difficulty paying for increased insurance premiums on the house, increased maintenance and raw material costs for the house, health care expenses have increased, transportation costs have increased, and now that social security and pension check doesn’t pay what it once did.

Grandma Neely wasn’t the only one hit by the inflation tax. Inflation is an issue that effects billions of people throughout the world. So it’s essential us to have an understanding of how inflation effects our purchasing power over time.

Inflation is the general increase in prices. And even if prices stagnant, it’s likely that the value of paper money will decrease over time. This will have an effect on investments made over time, as well as your purchasing power. This hasn’t been the case of late, but if history is any judge — we should be prepared for it in the future.

Trends in Inflation / Deflation

Inflation / deflation trends can have a drastic outcome on the value of businesses.

During an inflationary environment, stock investors can do very well. Think about it — as investors we are always trying to purchase future free cash flows or assets at a discounted value. If the value of goods and services, as well as tangible assets increase over time (which they more than likely will), you will be in a great position and it affords you an even greater margin of safety. Real estate, as well as various commodities, tend to increase over time with inflation.

Thus, if you are buying a business that is trading at a 60% discount from its tangible book value, your margin of safety could be greater if you expect an inflationary type environment. Of course, it’s during such periods of inflation that market folly can take over and the reptilian or animal brain takes over.  This is why it’s always prudent to value securities in a very conservative manner.

Personally, I have found interesting opportunities in companies that are trading below tangible book values, but also have an added kicker in the form of "hidden assets." Peter Cundill, in his book There’s Always Something to Do, talks openly about investing in securities with hidden assets. His approach intrigued me greatly and I highly recommend the book. Although my philosophy has shifted more to great businesses at reasonable prices, I continue to search out hidden assets to provide an even greater margin of safety.

During deflationary environments, assets and markets tend to decrease in value. So buying a security at a 60% discount from tangible book value may not give you the margin of safety you expect if assets are decreasing in value. Of course, this depends on how the assets are recognized on balance sheet as well.

In deflationary times, these hidden assets can easily become impaired.  Real estate carried on the balance sheet at historical cost could decrease below historical cost, over funded pensions can be eroded and subsidiaries within the parent company can encounter difficult business environments during a deflationary period.

A prolonged deflationary environment can wreak havoc on the stock market. This is normally a stock investor’s worst nightmare.

This is always a possibility as a stock investor.  Anything can happen in the markets at any time.  In a manner of speaking, an investor should always expect the unexpected.

The best case scenario for long-term investors are bouts of deflation. It is not fun to be in the middle of a pro-longed deflationary market environment.  No one wins in a deflationary environment short-term.

However, it’s during these periods that investors can accumulate positions in great businesses at incredible prices. The only way to invest during deflationary environments is with a significant margin of safety, and even then it may not be easy.

This is the essence of investing. We have to come to grips with the fact that there are many things that we will not know when it comes to investing.  Are we entering a period of inflation/deflation?  How large should the margin of safety be in an inflationary environment versus a deflationary environment?

So How Do Individuals Invest To Counteract Inflation?

It’s interesting to note that Benjamin Graham makes the case for a 50/50 split of stocks and bonds in his book The Intelligent Investor. This will fluctuate to 75/25 or vice versa, depending on the markets optimism (overvaluation) or pessimism (undervaluation).

So why must portfolios have stocks AND bonds?

In one word — Stability! But more importantly — Stability in the face of uncertainty. You are seeing this more and more with the systematic asset allocation strategies and Robo-advisors.

Ultimately, we have no idea what any market will do. Even if we believed the stock market were overvalued at current levels, it does not mean it couldn’t stay range bound till underlying business fundamentals come more in line with the current valuations.

As we know, Bonds are the debt obligations of a business. The interest and principle payments are enforceable by law, and must be paid by the business (just like any debt). On the other hand, if you invest in only stocks, it is very difficult to force the business to pay dividends or repurchase shares. As you can see, there is a greater probability of income during a market downturn with bonds.

Bonds give the investor a fixed interest payment at that moment in time, regardless of inflation.  Basically, the payment you receive from your bonds today, will likely give you a decrease in purchasing and earnings power in the future due to inflation. That’s why an investor should never solely invest in bonds.

There is a balancing act that must go on between stocks and bonds because bonds provide no protection against the high probability of inflation (and devaluation of paper currencies).

This is where stocks come into play versus (the near certain) future inflationary forces. Inflation has occurred throughout history and investors must be prepared for inflation well into the future.

Although stocks are not the "perfect" protection against inflation, they will provide some. Historically, stocks have outperformed inflation over 70% of the time. So as you can imagine, stocks will provide a much higher probability of protection versus bonds.

Essentially, stocks guard against the loss in earnings power from inflation and bonds can help protect against the downside losses from deflation and falling stock prices (all else being equal).

The portfolio of a smart investor consists of both stocks and bonds because the risk of allocating everything in one basket is too great. Studies have shown investors make bad decisions from the extremities of market volatility — or even worse, permanent capital loss.

So what’s the perfect ratio of stocks vs. bonds?

It depends.

There is no "perfect" ratio — however there is an "adequate ratio" and it depends on two main things.

• Stock Market Valuations
• Interest Rates

In the U.S., interest rates are at all-time lows and equity markets, by historical measures, are nearing the upper echelon of overvaluation.

As we know, bonds are likely to suffer from the eventual rise in interest rates from such low levels. And it would not be surprising to see a pull-back in equity markets as they digest this 6-year bull market run. We could potentially see a drop in both the bond and equity markets.

In light of today’s market and current valuations, it wouldn’t be surprising to see investors with a mix of 60-70% in stocks, 10-20% in bonds, and 0-10% in cash (or more).

There are other countries in the complete opposite situation. For example, Brazil is going through a very difficult period right now with interest rates at 13.25 % , inflation hovering around 7.6%, and a stock market that looks reasonably valued. In this instance, a 60/40 or 70/30 split between stocks and bonds would not be out of the realm of possibility in this circumstance.

Things are not great in Brazil right now. Many are calling this the "perfect storm." However, I would not be surprised to see a reasonable rate of inflation and interest rates over time (reversion to historical rates). This in turn will be great for stocks and bonds, so at this point it depends on your risk tolerance.

BOTTOM LINE: Armed with the "bigger picture backdrop" and understanding that inflation is likely to persist over time, investors can position themselves to reap the benefits of compounded returns over the long-term with little decrease in purchasing power. Investors are likely to accomplish their goals through the selection of risk-averse stocks and bonds (more weighted to stocks).