Invest to hedge for inflation
Posted by Frugal on April 25th, 2006
According to the Efficient Market Hypothesis, the stocks are always fairly priced. Whatever information and news will be reflected by the stock price almost immediately. The current market capitalization of a given stock to the entire market is the best allocation percentage using all available news and information. This is the philosophy of the passive index investing.
Using the spirit of efficient market hypothesis, a person can invest to hedge inflation of his or her expenses by studying his or her expense budget. Using my budget as an example, my total expenses including property tax, but excluding income taxes and charity contribution is $3805 per month. I categorize expenses roughly into the followings (please refer to the table of my budget):
- Food: $360
- Car: $45 insurance + $40 maintanence = $85
- Housing: $1270 mortgage + $165 HOA + $225 property tax = $1660
- Communications: $16 local + $7 mobile + $20 long distance = $43
- Energy: $45 electricity+ $55 gas + $135 gasoline = $235
- Utilities: $25 water + $13 trash + $17 cable = $55
- Medicals: $127
- Travel: $220
- Consumer Staples/Clothing: $100 (baby) + $300 wife’s + $80 cash + $100 misc = $580
- Education: $440 preschool
Here is the summary table:
|
Expense |
Amount |
Percentage |
|---|---|---|
|
Food |
360 |
9.5% |
|
Car |
85 |
2.2% |
|
Housing |
1660 |
43.6% |
|
Communication |
43 |
1.1% |
|
Energy |
235 |
6.2% |
|
Utilities |
55 |
1.4% |
|
Medicals |
127 |
3.3% |
|
Travels |
220 |
5.8% |
|
Consumer Staples |
580 |
15.2% |
|
Education |
440 |
11.6% |
So if I want to hedge against the inflation of my expenses, I would invest in accordingly the related industries. Of course, you may also want to consider the input factors into a particular industry along with that industry. For example, to hedge against your costs of airline tickets, you definitely want to consider the cost of gasoline energy that goes into airplanes. And for calculating your investment for housing costs, you should take out the mortgage, but do include the rent. Mortgage itself is already your investment into your own housing.At last, you don’t need to over-hedge your expenses. If you assume an operating margin of 10% (or stock return of 10%), you only need to invest $43 * 12 months / 10% = $5160 in the communication industry. If the overall revenue of communication industry grows, most likely so will your expenses and your investment profits.
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April 25th, 2006 at 9:09 am
I disagree with what you wrote about the Efficient Market Theory. If what you wrote is correct and “stocks are always fairly priced,” how does one explain the occurrence of market crashes? I don’t see how Cisco could have fairly priced at $69/share with a trailing P/E ratio of over 100 in April 2000 and currrently fairly priced at about $20/share with a trailing P/E ratio of about 23 today.
The Efficient Market Theory may tell us that, on average, stocks are fairly priced. However, as a theory of current valuations, it isn’t very helpful.
April 25th, 2006 at 1:59 pm
I don’t subscribe to Efficient Market Hypothesis fully either. I’m only borrowing the ideas derived from it, for indexing in a similar fashion for investing to hedge for inflation. The debate of whether Efficient Market Hypothesis is correct is not the focus of this post. But if you invest in any of the market index fund, then your money, if not your mind, is in that camp. To answer your question from my understanding, cisco is priced fairly now, and was priced fairly back in 2000 too. In the Efficient Market Hypothesis, there is really no place for future or past. It’s always NOW. Essentially the current market capitalization is the current opinion of all participants who have all available news and information. And yes, it’s completely useless for valuation.
May 11th, 2006 at 12:47 am
I would be very careful of Jim Jubak’s advice. I’m surprised he wasn’t fired. Most of his recommendations lost 90+% during the last mini-recession. He doesn’t invest real money, or he would have been broke long ago, haha…
May 11th, 2006 at 11:57 am
Thanks for your warning. I’m going to remove his link. I just started reading his stuffs, and it seems to make sense. But historical record is the best for judging one’s performance.