The stock market racked up another stellar year in 2021, after the huge gain in 2020. In the real world of daily life, however, conditions haven’t been as rosy.

The pandemic is still very much a threat. Most of the population has been vaccinated but new COVID variants are still causing massive new breakouts. Those of us hoping for a return to our normal way of life in 2021 were disappointed.

Besides the health threat, COVID-19 has had another huge impact on us all. Prices for everything are skyrocketing. By the end of the year, inflation as measured by the consumer price index (CPI) had reached the highest rate in almost 40 years (see first chart below).

The second chart shows how much inflation has risen in the last four decades. The latest CPI value of 276 means that a good that cost $100 in 1982 now costs $276. Put another way, the buying power of one dollar is only 36% of what it used to be in 1982.

Since the end of 2011, inflation in the U.S. stayed remarkably low, never breaching 3% in any month for a stretch of more than 9 years, until the pandemic brought on the current rise in prices.

One could argue that the CPI understates actual inflation in the real economy, but there’s no doubt that inflation is much higher now. Some inflation is normal and healthy, but when inflation rises too much too quickly, it works as a major tax hike on consumers.

The Danger of Inflation

In a consumption-driven economy such as ours, rapid inflation could lead to a downward economic spiral. Besides reducing American consumers’ spending power, high inflation could also force the Federal Reserve to tighten monetary policy. Indeed, last week’s release of the minutes from the last Fed policy meeting (December) sent stocks tumbling.

The summary showed that Fed officials might have to raise interest rates sooner than expected. Higher interest rates not only tend to lower economic activity, they also reduce the appeal of risky assets like stocks.

When U.S. Treasury securities (regarded as “riskless”) yield next to nothing, investors are more willing to invest their money in stocks (regarded as riskier than bonds) in search of better returns. The Fed’s extremely dovish policies have been a tailwind for the stock market.

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Thus, tighter monetary policy could be a double whammy for the stock market. Slower business activity means slower (or even negative) corporate revenue and profit growth. Plus, stocks would look less attractive compared to Treasury notes that offer higher yields for little perceived risk.

We Still Favor Stocks

However, this doesn’t mean that one should indiscriminately sell stocks and buy bonds. During inflation, if you own bonds that pay a fixed rate that doesn’t adjust for inflation, you actually lose spending power. As we showed earlier, due to inflation, the same dollar doesn’t buy you the same amount of goods over time. If you invest in a quality dividend-paying company, on the other hand, the dividend will typically grow over time, mitigating or even overcoming the effects of inflation.

Furthermore, historically stocks have strongly outperformed bonds. According to Morningstar research, since the end of the Great Depression, over a period of nearly 90 years, large-cap stocks as a group have returned about 9.6% per year. Over the same period, government bonds have returned about 5.6% a year.

That may not sound like a big difference. But over time, due to compounding, the difference really builds up. Never mind 90 years; let’s just use 20 years (a reasonable long-term investment horizon) to illustrate.

If you invested $10,000 in a large-cap stock portfolio and $10,000 in a bond portfolio 20 years ago, at the annual rates of return noted above, today your stock portfolio would be worth about $62,500 and the bond portfolio about $29,700. The overall dollar return of the stock portfolio is more than double that of the government bond portfolio over the 20 years.

Know Your Situation

Of course, the 9.6% and 5.6% figures are annualized averages over a long period of time. Actual year-to-year returns can be quite different from the averages. In recent memory, the stock crashes from the 2008 Financial Crisis and the COVID-19 outbreak are stark reminders how fast stocks can fall. The volatility of the stock market is why some investors remain fearful of the stock market.

However, unless the economy is permanently impaired, stocks will come back. Those who stayed in the market made their money back and then some. How you allocate your investment depends on your risk tolerance and when you may need to tap your investment portfolio for cash needs.

It goes without saying that the point of investing is to make money, but it’s very important to understand your personal financial situation and your future financial needs to form a strategy that fits you. If you’re looking for a trading methodology that provides big gains but also mitigates the risks that await in 2022, click here.