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Today's Commentary: 05.07.04
Hedging the Risk of Inflation
by Larry Swedroe
The process of building an investment plan, and deciding upon the appropriate asset allocation, is a complex one. The reason is that there are many issues that should be considered. The issues include such factor as the investors: ability to take risk (which is dependent on the investment horizon and the stability of earned/unearned income); willingness to take risk (how much one can tolerate the stomach acid created by inevitable bear markets without panicking and selling, or even losing sleep); and need to take risk (the rate of return needed to achieve one¹s goals. When determining the need to take issue, the investor should consider his/her utility of wealth curve‹how much is any potential incremental wealth worth relative to the risk that must be accepted in order to achieve the greater expected return? While more money is always better than less, at some point most people achieve a lifestyle with which they are very comfortable. At that point, the taking on of incremental risk required to achieve a higher net worth is no longer acceptable to most people.
The reason is that the potential damage of an unexpected negative outcome far exceeds the benefit that would be gained from incremental wealth. Thus each investor needs to decide at what level of wealth their unique utility of wealth curve starts flattening out‹begins bending sharply to the right. Beyond this point there is little reason to take incremental risk in order to achieve a higher expected return. While there are many other considerations we will turn to the issue of the risk of inflation.
Inflation can lead to devastating effects on the ability to maintain a desired lifestyle for those whose incomes do not keep up with the rising costs of living. During one¹s working career the risk is generally not great as wages typically keep up with inflation. Thus employment is a hedge, at least to some degree, against the risk of inflation. The risk of inflation, however, increases during retirement. Those living on fixed incomes, or relying on longer-term fixed income investments to provide the cash flow needed during retirement, should be more concerned about protecting themselves against unexpected inflation.
One bit of conventional wisdom is that real estate acts as a good hedge against the risk of inflation. Unfortunately, both the earth is flat, and the earth is the center of the universe, were once considered conventional wisdom. To determine if real estate is a good hedge against the risk of inflation we can examine the historical evidence.
We will examine the correlation of real estate returns, using the Wilshire All REIT (Real Estate Investment Trust) Index, to inflation. For the period 19782003, the annual correlation was 0.31. This indicates that there has been a significant positive correlation‹exactly what we would want to see from an asset that we are using to try to hedge the risk of rising inflation. Thus we can conclude that in this case, the conventional wisdom is correct.
We can also test to see whether REITs are as an effective hedge against inflation risk as are equities in general‹is it that REITs are equities that provides the inflation hedge, or is it instead some unique characteristic. For the same period, 19782003, the correlation of the S 500 Index to inflation was zero. If we extend the period back to 1926, the correlation of the S&P500 Index to inflation is actually slightly negative at -0.02.
In summary, we can conclude that investors that are at risk to inflation should consider including an allocation to both REITS and commodities to their portfolios‹and the greater the risk of inflation, the greater the allocation to these asset classes that should be considered. And finally, it is also important to note that both TIPS (Treasury Inflation Protected Securities) and I Bonds are fixed income investments that offer a hedge against the risk of inflation (as do all very short-term fixed income instruments).
Note from the Editor
Larry often contributes to the BlueMoney Report and we thank him for insights, which are not to be confused with as opinions of the BlueMoney Report.
Larry Swedroe is the author of "What Wall Street Doesn’t Want You to Know" and is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Today's Commentary: 05.04.04
Are Stock Analyst Recommendations Worth Anything?
by Larry Swedroe
One of the methods investors use to select individual stocks for purchase is to rely on the stock recommendations of a brokerage firm. The question is: Do these recommendations have any value? J. Randall Woolridge sought the answer to this question in his study, "Performance of Stocks Recommended by Brokerages" (Journal of Indexing, Spring 2003, pp/ 23-33.).
Using data from Zacks Investment Research he studied the stock recommendations of as many as seventeen major brokerage firms for the decade ending in 2002. The following is a summary of his findings:
- The stock recommendations of major brokerages produced lower returns (2.17 percent per quarter) than the S&P 500 Index (2.26 percent per quarter).
- Their stock recommendations exhibited higher volatility than did the S& P 500. Recommended stocks exhibited a standard deviation of 9.7 percent vs. 8.5 percent for the S&P 500.
- The returns of the recommended stocks were highly correlated with that of the S&P 500 (an r-squared of .92) but had greater risk (a beta, or exposure to market risk, of 1.1).
- When the returns of the recommended stocks were regressed against the Fama-French three-factor model the correlation was even higher, between .93 and .95. Thus it was the asset class to which the recommended stock belonged that was the determinant of virtually all of the returnsthe choice of the individual stock that was recommended had almost no impact on the return. The alpha, or value added, was also zero.
The bottom line is that the stock recommendations of brokerage firms produced no value added; yet investors were accepting greater risk (with risk defined in this case as volatility). It is also important to note that the above results included neither an estimate of transactions costs (bid-offer spreads and commissions) nor the impact of taxes. In both cases the impact on the results of the stock recommendations would have been negative relative to the results that could have been achieved by investing in a low cost S&P 500 Index fund or an S&P 500 ETF.
This study adds to the body of evidence that the market is highly efficient (the market’s current price is the best estimate of the correct price) and that trying to exploit perceived mispricings is only likely to make the brokerage firm rich. Which is why, despite the evidence that the stock recommendations of brokerage firms have no value, brokerage firms keep producing themso they can profits from trades investors are better off not making.
So the answer to the question posed in the title of this article is: It depends. For brokerage firms the answer is a clear yes. However, for investors the answer is an emphatic no.
Note from the Editor
Larry often contributes to the BlueMoney Report and we thank him for insights, which are not to be confused with as opinions of the BlueMoney Report.
Larry Swedroe is the author of "What Wall Street Doesn’t Want You to Know" and is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
