In today’s episode of The Rational Reminder, we tackle the subject of inflation in a twofold manner. Firstly, there are details around how people perceive inflation that often get overlooked, and secondly, these expectations have investment implications that are worth unpacking. Before diving into the main topic, we talk about Colin Bryar’s Working Backwards which tracks the role of failure and customer obsession in Amazon’s growth path. After getting into this week's news and listener question, we begin the first part of our session on inflation. Some of the main points we make here are that everybody experiences inflation differently, that perceptions of inflation are connected to experience, and that biased inflation estimates can explain household borrowing and investing behaviour. This leads us to part two of our discussion, where we unpack how expected inflation influences asset pricing and the role of unexpected inflation in the performance of stocks and bonds. We attempt to locate other asset classes that can act as inflation hedges, but find that with the tradeoffs and poor correlations involved, it makes the most sense to vouch for a properly diversified portfolio of stocks and bonds with exposure to multiple sources of expected return. So before you base too much of your decision-making on inflation, be sure to consider some of the points we make in today’s show.

Key Points From This Episode:

• TV shows, listener feedback, Peloton’s stock price, and RRP updates. [0:00:19.2]

• Lessons from Amazon’s growth story in this week’s book, Working Backwards. [0:07:55.2]

• News: Vanguard’s ‘High-Conviction Active Funds’ and Wealthfront’s intention to sell. [0:14:23.1]

• Whether size premium is influenced by a reduction in IPOs and publicly traded companies. [0:17:36.2]

• Main topic: Overlooked aspects of inflation and their implications on investing. [0:23:46.2]

• Metrics from the CPI and how everybody experiences inflation differently. [0:26:36.2]

• How to work out your personal inflation rate and what Ben and Cameron’s are. [0:28:07.2]

• Inflation expectations are influenced by inflation experiences. [0:30:43.2]

• Biased inflation estimates can explain household borrowing/investing behaviour. [0:34:03.5]

• The implications of the fact that the CPI doesn’t account for substitution. [0:36:07.2]

• Debunking the assumption that those close to retirement are most exposed to inflation. [0:39:13.2]

• How financial assets are priced using discount rates and the effects of unexpected inflation on them. [0:43:36.2]

• The effects of high, low, and expected inflation on stocks and bonds. [0:45:41.2]

• Whether other asset classes than stocks can be inflation hedges. [0:48:15.2]

• The relationship of different commodities to inflation at different periods and regions. [0:53:05.2]

• Questions of status, greed, and decisions in this week’s Talking Sense. [0:56:54.2]

Read the Transcript:

Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital.

Cameron Passmore: Welcome to episode 178. Have a couple of quick show references for you. One, I'm sure most people are already watching, which is Yellowstone. You watching Yellowstone by chance?

Ben Felix: No.

Cameron Passmore: The Dutton family ranch? Oh, my God! It's fantastic. Kevin Costner, crazy, awful, things that they do to protect their land in Montana. It was a great show. Another one, remember a couple weeks ago we talked about a '90s show that Lisa and I watched. So a friend of ours, Chris, reached out and said, "Oh, you got to watch the Dark Side of the '90s, which is on Crave in Canada." So we started watching it yesterday. Wow. To go back to these times pre-internet and pre so many things, the episode yesterday we watched was about the Beanie Babies, which I was not a Beanie Baby fan, but to learn that online selling on eBay basically started with Beanie Babies if you can believe it.

Ben Felix: Wow.

Cameron Passmore: Completely crazy, but even the sounds, dial up internet and all these things at the time that they referenced, it was certainly for people lived through the '90s. It was really interesting. So we're hooked on that show, too.

Ben Felix: Wait. So what's the dark side? You just talked about Beanie Babies and dial internet. What's the-

Cameron Passmore: Well, the dark side that they talk about, one is that talk shows were created in the '90s, Oprah and then led into Jerry Springer. The dark side of that was talking about how Jerry Springer basically capitalized on the worst part of humanity and made it a television show like a car crash. You just can't stop watching this horrible stuff. Then that morphed into what the internet in the late '90s took over with sharing of all kinds of crazy stuff.

Another dark side was, we're only two episodes in, was the whole drug scene in LA. So what's the name? The Viper. Was it called The Viper Lounge or something, a famous club in LA and River Phoenix dying. So they talk about with that. So those are some of the dark sides. Anyways, the dark side of Beanie Babies was how the creator, Ty, I forget his family name, but the creator of Beanie Babies ended up cutting off supply of certain Beanie Babies, which made the price go through the roof, and then he said at the end of 1999, where he stopped making Beanie Babies, so of course the prices just kept going up. People buying out supplies everywhere around the world and fighting over Beanie Babies and even the baby Beanie Babies at McDonald's, and then only a few months later to come out and say, "Oh, we're coming back with new Beanie Babies." So the price plummeted and the whole thing imploded.

Ben Felix: Crazy.

Cameron Passmore: Completely crazy. Some great reviews lately. I Love Tofu said that, "I love this podcast, but I heard the opening as from two Canadians. I wasn't sure if it was relevant to me as a non-Canadian."

So we did make the change that was suggested here from a couple of Canadians. Hopefully, it's more clear now. We think it is.

Ben Felix: Oh, they've understood it as from Canadians, to Canadians. From/to is what they wrote. It's now from two people who are Canadian.

Cameron Passmore: That's true. I didn't pick up on that. It's from a couple of Canadians. R2134 said, "Great knowledge and summary. This podcast will make you better investor. You could take the time to listen closely and reflect unlike many podcasts, which are a little more than opinion editorials." That's very nice. Thanks so much for that feedback.

Life Like No Other said, "This is a great resource for financial literacy."

Marie Roy said, "Can't recommend this enough. I started listening to the podcast in the beginning of 2021. Does not miss a single episode yet. As a newbie in the finance space, I can't see. I completely understand all the minutia and details that we go into with our guests, but I've enjoyed each episode and consider them as an opportunity to learn something new," which is what we're trying to accomplish here.

Also, Marie said that she's gotten a lot more out of her Audible subscription thanks to my amazing book recommendations. I never know how the book recommendations go, but a few people have said they enjoy them.

Ben Felix: You know people like them. That's one of the most frequent feedback that we get on the podcast is how much people like your book recommendations.

Cameron Passmore: From the store, get your order in for Christmas. We're getting orders out right away as they come in. Let's face it. Who doesn't like one of our hoodies? Hoodie sales have been slow lately, but do you know what's selling like crazy? Are these talking sense cards. We have to put in another order. We're almost through 250 packs.

Ben Felix: Wow.

Cameron Passmore: If you can believe it. We have maybe, I don't know, 30 or 40 left, I think, in the storage.

Ben Felix: That's wild. I would've guessed that would've been like a year's supply. How long did they take us to go through them?

Cameron Passmore: What's it been? Three months maybe.

Ben Felix: Wow.

Cameron Passmore: So Angelica has ordered more. Just a reminder, we run this store pretty much breakeven after shipping. So love to get more merchandise out there to you. Just a reminder, connect with us on Instagram, @RationalReminder. I'm on Peloton, @CP313 and #RationalReminder. Speaking of Peloton, have you seen their share price lately? It's down 75% from its pandemic high. So I heard Scott Galloway on a podcast this morning suggesting that with the valuation now around 16 billion US, he's saying it should be a great takeover target for a company like perhaps Apple or even better he says Nike because Nike desperately needs to get into the digital space. So he thinks it would be a great take over target there.

He says, "I don't care about valuations." He says, "Just to get that kind of audience, it'd be worth even 50% premium of a current share price." That is not a stock recommendation, just an anecdotal story looking at something that's dropped so far so fast.

Ben Felix: Did they talk about why or have you heard about why the price is down so much? Just bad earnings or what?

Cameron Passmore: I think bad earnings. I think a lot of people are hopping off of Peloton in post-pandemic and going back to the gym. The average user's uses per month is falling. Anything else to add?

Ben Felix: Nope. I've still never tried a Peloton. I've got my fan bike. I met a guy who does welding and he made some stuff for my house. I asked him if he could extend the seat on my fan bike because I'm pretty tall and the seat's not made for my height. So he took it and he's extending it for me. It's pretty, pretty exciting.

Cameron Passmore: Get to extend the handle bars also?

Ben Felix: I usually actually don't use them. I usually sit back and don't use the handle bars. So I think if I were to use the bike properly, I would have to extend them, but I have not been using them.

Cameron Passmore: Well, one last thing I wanted to put out there was for those that haven't checked out, the podcast on YouTube, it's really worth checking out. Our animator, Matt Gambino is doing some fabulous work every week improving it, and it's really good.

Ben Felix: Yeah. It's very cool to see his creativity coming through just the way that he presents the videos, but also he's working in more graphics. We've tried to do that historically when possible, but having Matt on the team with us just makes it a lot more seamless, I guess, to do stuff like that. So yeah, that's been cool.

Cameron Passmore: He is also working hard on the year end show, which I think we're going to have more than 40 little clips of audio. So he's going to do a nice job on that, I'm sure.

Ben Felix: You put that together. You put all the clips together or assembled all the clips for the year end show. You said it was a pretty impressive year of conversations to review.

Cameron Passmore: Incredible year of conversations, but you realized that my job is a whole lot easier than what Matt has to do to pull us all together from a video standpoint. It's going to be incredible episode, hard to get it down to a few dozen audio segments, but we'll see. I'm sure what I've chosen, what you would choose would be different, but no matter what, when you got a line light we've had this year, it's going to be a great year end wrap up.

Ben Felix: I mean, you've nailed it the last couple years. So I wouldn't worry about differences in how each of us would do it.

Cameron Passmore: All right. Shall we get to the episode?

Ben Felix: Let's go. Welcome to episode 178 of The Rational Reminder Podcast.

Cameron Passmore: I have a great book review for you this week. In fact, it's a bit of a combo review. So it started with our good friend, Aydin Mirzaee, who is the CEO of Ottawa-based Fellow, and he hosts the podcast called Super Managers. He recently interviewed Colin Bryar in episode 70. So Colin Bryar, for those who don't know, was Jeff Bezos' right-hand person at Amazon for many years.

So Aydin's interview inspired me to go and read the book that Colin co-authored with Bill Carr called Working Backwards: Insights, Stories, and Secrets from Inside Amazon. Aydin's interview was phenomenal. The a book is phenomenal. I learned so much and I'm going to be like Aydin, which you go back and reread this book a number of times. I already listened to the interview twice. So Bryar and Carr are both former execs at Amazon and were there very early on, and they were a significant part of the executive team during the early years of what is obviously an unbelievable growth story. So they wrote this book to articulate how leadership and management works at Amazon. Did you know that Amazon now has over 1.3 million employees? It's just mind-boggling.

Ben Felix: That's a lot of people.

Cameron Passmore: A lot of people, a lot of product lines, a lot of verticals. So how do they ever pull this off? So that's what this book is about. So I'm not about to go through a complete summary, but there are some pretty cool takeaways. So the title, Working Backwards, simply means to be customer-obsessed. Jeff Bezos is absolutely customer-obsessed. So you're all always working backwards with the customer problem, being objective of what you're trying to solve.

I mean, a perfect example last night were at home and my probe in my oven to do a roast broke. Within 30 seconds, I had a new one ordered on Amazon. You think of the old days. Where would you go to find it? You got to drive across town. Oh, they don't have it in stock. 30 seconds and it's at home now, it's already been delivered. This is Sunday night I ordered it.

Point number two, even in the face of urgency, it's critical to hire the right people. Hire your weight of a problem, but hire properly. So they call it the bar razor process and they have a whole process. They go through it in the book about how they do interviews and how they avoid bias in interviews, how they avoid bias in ranking, how everyone felt about the interview. Very, very impressive.

Number three, which we've talked about before, which is breakout teams into smaller decision making units. They call the two pizza groups. So to keep the entrepreneurial feel, they want groups to be able to be fed by two beaches. So it's probably like 10 people or so is an ideal group size.

This next one is pretty interesting. You must fail often to hit it big. So for example, they failed miserably with a fire phone. However, they had monster success with the Kindle, Amazon Music, Amazon Prime, Prime Video, Alexa, AWS, and all of these items were questioned big time before they were launched.

This is another really cool one. As issues would come up and they become bigger, more complicated, they came up with a process to enable a leadership team to make better decisions. So the end result was that PowerPoint was forbidden. Any proposal you had, it had to be done in a written format because a written format forces more consideration by the presenter, more clarity of thought, more effort, and it gives equal weighting to the quality of the work that goes into it, not on the ability of the presenter to work PowerPoint. So they said it's a better way to get better ideas and better information shared to all people, and the crux of the decision to better focus for the people to make decisions. I thought that was a great idea.

The other thing they always do before going ahead with a new project is they write a press release and that press release, of course, is not issued, but it's an example of what they do to think about the client problem they're solving is to highlight the benefit to the customer in that press release.

Another thing they do, too, is they focus on the input metrics of the business more so than the output metrics. What are the activities that you can control? They focus on that much more than the profitability on the other side. Then they go into some examples of product lines that came to life like Kindle. Absolutely brilliant. I love my Kindle, but the Kindle came out of the problem that the customer was having at the time because there were books coming out, but they're not easy to read on the iPad, for example, on different computers.

Jeff Bezos wanted to get a device where you could have all in one spot, a comfortable device, easy on your eyes, easy to order as things came up. That's where the Kindle came from. Clearly, it worked. Amazon Prime came up with solving a problem of customers were having, which is they didn't like the delivery cost. That was the biggest hurdle to placing orders was the shipping cost. This took care of that. Prime video, crazy. I mean, this was a series of failures before they decided to create their own content. So create and curate on one side and deliver on the other side. In fact, remember Jennifer Risher was on back in episode 145. So her husband, which we talked about in that episode, was part of the book because he was Senior VP of the Prime delivery execution.

Then the last one I'll highlight is AWS, which is a monster part of Amazon's business. AWS simply started as a service for querying the referral program, and then it became an API for the web store, but the problem they wanted to solve was, as they put it, they wanted a student in a college dorm room to have the same amount of computing power as someone working at Google. That was the mission and they did it, and now look at the size of it.

So as they put it, the key principles that Amazonians follow are be customer-obsessed, think long-term, value innovation, and stay connected to the details. So phenomenal book. Can't recommend it enough, and shout out to Aydin for the interview and for the book recommendation.

Ben Felix: Very cool.

Cameron Passmore: Couple news articles that I came up with last week that I thought might be interesting for us to talk about. So just quickly, these two articles, one talks about how Vanguard, which is a very strong player in the Independent Advice Channel with the Personal Advisor services, and we've talked about them before, they're coming out with five new what they call High Conviction Active Funds that will be offered only to the Personal Advisor Services clients. They talk about in the article how the goal of Vanguard is to make this service more attractive to high net worth clients.

It said potentially it'd be more profitable, but Vanguard's a mutually owned company. So I'm curious what their motivation is. Is it to make the product more sexy, more saleable? I don't think it's about margin capture.

The other article talks about how Wealthfront, which is the huge US-based robo-advisor, is looking for a buyer. So Wealthfront has 25 billion of asset center management. They tried to do a reverse merger with SPAC, but that failed. Wealthfront, and I didn't know this, how many times they pivoted, but they've pivoted every other year since they were founded in 2008. Most recently, they become like Robinhood allowing investors to be more self-directed, and we talked about that a couple weeks ago. They've also opened up the platform to cryptocurrency.

So it's interesting to read these two articles and go back to the Amazon story, which is if you're customer-obsessed, how did these moose fit into your corporate strategy? If you showed up to Wealthfront six to eight years ago and expecting an evidence-based globally diversified index portfolio of ETFs, you might be shocked today. It's more about gamification, quasi Robinhood, and crypto.

Same thing if you went to Vanguard and expected similar kind of experience. All of a sudden, now you're being, pitch may be a strong word, but being proposed high conviction active funds even though they're low expense ratio funds, it's like, "Is that what the advisor really wanted? So what's the motivation here? I don't have an answer. I just think it's an interesting question to think about.

Ben Felix: Yeah. I doubt it's for the advisors in the Vanguard case. It's potentially really for, like they say, it's to attract high net worth clients, which I can believe that. It's true that people want fancy stuff when they feel like they're a wealthy individual or if they feel like they're a high net worth individual. I think it's probably more common to see people seeking fancier stuff probably because it's often sold to them. So I would believe that one. The Wealthfront is fascinating. They were the ones that started the whole robo concept, and for a while there, everyone in traditional wealth management was concerned about the robo-advisors, but that clearly hasn't panned out.

Cameron Passmore: Not at all. In fact, the average fee charged by RIA advisors in the past decade hasn't moved, I think, more than a basis point or two. So people were petrified a decade ago.

Ben Felix: Very interesting.

Cameron Passmore: Anyways, we have a lot of listeners that work in this space. I'm sure there'll be lots of thoughts about this. I think it is interesting, though, for consumers to think about who's behind the firm that you're choosing to work with and what's their motivating factor for what they're bringing to you. Just worth of all questions to ask. All right. Listener question?

Ben Felix: Yup. So this question came up in the community. I thought it was worth touching on briefly. Somebody asked, "Has anyone looked at the trend of dramatically lower annual IPOs in the past 20 years compared to the prior 20 and the shrinking number of listed publicly traded companies traded in the US to see if either of these trends influence implied value premium."

There was a related paper from Dimensional white paper in 2017 or I think it was a 2018 paper, maybe, not on value, but on the size premium, which is I think what the question was really getting at. So Dimensional finds that from 1975 to 1997, the number of names in the US increased from 4,530 to more than 7,000. So that's 75 to 97, keeping in mind 97 was the late '90s when there were lots of IPOs. The number of stocks declined over the last two decades to approximately the 3,400 in 2017. Globally, this was interesting because they're saying, "Okay. There's this issue of declining stocks in the US globally."

It has not been the same. Global stocks have been increasing from 1990 to 2017. The number of names outside the US increased from 9,739 to 39,333. So downward trajectory for the number of names in the US, but big upward trajectory outside of the US. They find in the paper that the size premium has been pervasive across markets and the magnitude of the premium had no relationship to the number of stocks in each country. So that was pretty interesting, too.

They sorted countries by the number of stocks from fewest stocks on average to the most. The fewest number of stocks was Ireland. The most was the US. The average number of stocks, there's huge variation, obviously, as you can see that range. Ireland had 55 stocks on average and the US had 3,763 stocks on average over the time periods they're looking at. The monthly size premium in Ireland with 55 stocks was 0.47%. For the US with 3,763 stocks, the size premium was 0.18%. There was much other countries, too. These are just the ones that were in the text. There's a chart that they're speaking to in the text, the paper I was reading.

So Italy had 233 stocks on average with a size premium of 0.15% monthly. So they show with what I just said, but also in a chart they show that there's really no relationship between the number of stocks and the size premium in the countries in this sample. They say that the results for emerging markets were similar, but they didn't show that chart in the paper, but pretty interesting. So no relationship between number of companies in the size premium.

So then the next thing that they do to dig into this question is they asked if the number of the names at the time, so December 2017 data, 3,447 US stocks, they asked if that's too few stocks to observe a reliable size premium. That's the question, right? Is the number of names related to the size premium. So they took the full set of us data that they had, but they only took the largest 3,400 names and they held the number of names in the US market constant in this hypothetical example.

So 3,400 US stocks, but looking at the same time period, 1975 to 2015, and they're taking out the smallest stocks. So it's the largest 3,400 stocks and they find an annualized size premium of 2.22%. So even by taking out the smallest stocks, so you've got the 3,400 largest stocks in the US, holding the number of stocks constant, but the smaller stocks in the sample had a size premium of 2.22% over the largest stocks in the sample.

Cameron Passmore: So the smaller of the 3,400 names.

Ben Felix: Yup. So the largest 3,400 stocks in the US market, that's the sample, but you can still sort that into larger and smaller stocks and the smaller stocks still had a size premium. So the point they're making, really, is that there's no relationship between the number of listed in stocks and whether or not we should expect a reliable size premium. We asked a related question to Jay Ritter when he was on because I've heard the narrative and I read a portion of the listener question, but they had a little bit more in their community post related to M&A and private equity and venture capital and all that kind of stuff, mopping up the companies before they can deliver a size premium.

We asked Jay Ritter about that because of that potential phenomenon where private equity is funding what would've previously been the small caps would've delivered a premium should be investing in private equity. Professor Ritter's answer was basically no, and he gave more logic behind that, but that was the answer, and it was basically because the ... He referenced a paper, it came out last year, that looked at the returns of private equity managers and found that they have I think from 2005 to 2020, I believe was the sample, and he found that private equity funds delivered about the same returns as an appropriate public equity benchmark, which would've been like small cap value benchmark.

So private equity delivered about the same return, but charged massive fees. The paper was called, I think, something to do with the billionaire factory because private equity as an industry has generated a bunch of multimillionaire and billionaire fund managers, but the investors in the funds have gotten roughly the same returns. They could have gotten much cheaper from public equities.

Cameron Passmore: So interesting.

Ben Felix: Yup. So that's that. I don't think that the reduction in the number of names or the reduction in IPO activity has a whole lot to do with size premium.

Cameron Passmore: So for the main topic, hard to believe, inflation's on people's minds.

Ben Felix: Yup. Figure it's appropriate to talk about it. So I want to talk about some details of inflation that often get overlooked, but then also talk a little bit about the potential investment implications because there's two things, right? There's stuff gets more expensive that makes your consumption more expensive is one side of the inflation problem, but the other side of it is that it affects asset prices.

So you might be worried about stuff getting more expensive, but you might also be worried about your portfolio declining because you own stocks and bonds, which as we'll talk more about both tend to be negatively affected by high unexpected inflation. So we can try and touch on both sides of the inflation discussion.

So as I alluded to, when stuff and services get more expensive, your dollars, by less of them, so as most people understand that that is inflation and it's problematic for investors because what are we trying to do by investing? Typically, we're investing to fund future consumption, and if stuff and services are getting more expensive, well, you've got to save more or you've got to spend less or you've got to earn higher investment returns to keep all else equal.

As I mentioned as well, high unexpected inflation can have negative impacts on stocks and more so on bonds. So stocks and bonds are not inflation hedges. Longer term bonds tend to do really poorly, but stocks, which some people I've heard say are an inflation hedge, they're really not. They tend to do worse than average when inflation is high. So that's definitely not a hedge.

In the long run, stock returns have outpaced inflation, but that's a risk premium. That's very different from a hedge. You could maybe call them a long-term hedge, but I don't know if that makes as much sense.

Cameron Passmore: Yeah. I saw someone on Twitter last week comment like, "You worry about inflation at 4% or 5%. Meanwhile, your portfolio is up 30 plus percent."

Ben Felix: That's pretty good. It's true. In October 2021, and this is what has people worried, I mean, the US inflation's been picking up, too, but, obviously, we're here in Canada. The Canadian consumer price index was up 4.7% year over year in October 2021, and that's up from a 4.4% increase in September. The October increase was the largest since February 2003. So it sounds scary, but as I mentioned, to kick this topic off, I think there's a lot of stuff that gets overlooked. So we'll try and touch on that.

The first one that I think is important for people to understand is that everybody experiences inflation differently. So you take at the Canadian consumer price index, it's a representative basket of goods or it's a basket of goods that's designed to match what would be consumed by a representative Canadian household. So the Canadian CPI includes food, shelter, household operations, furnishings and equipment, clothing and footwear, transportation, health and personal care, recreation, education and reading, and alcoholic beverages, tobacco product and recreational cannabis.

That's actually a category. They say recreational cannabis.

Ben Felix: Well, it's part of alcoholic beverages, tobacco products and recreational cannabis. It's all one category. Now, I didn't write down the specific weights in the basket, but there are specific weights. Again, meant to be representative. The most weight in the basket is shelter and household operations, food and transportation. So that makes up a huge chunk of the overall basket, but even with that, every household is going to spend proportionally different amounts on just those major items, let alone all the other stuff.

You laughed about recreational cannabis. That might be a major expense in some households. In all seriousness, it could be, and that's going to be different from the representative household. So I think the first thing that people have to do before seeing like, "Oh, no. Inflation's 4.7%," is take a step back and figure out what your personal inflation rate is, and you can do that if you have a budget. I guess it's really easy because you can compare your own month over month or year over year actual spending numbers, but Statistics Canada does have a personal inflation calculator on their website. So you can use the Statistics Canada data, but you can narrow it down to your province and you can narrow it down to your specific budget.

So you put in what you spend money on per month and then they'll allocate the weights to your specific personal inflation basket, and then they'll tell you what your personal inflation was over the given time period. So when I ran my own numbers based on where my family tends to spend, my personal inflation rate was 3.1% year over year in October compared to 4.7% for the representative basket, and then even beyond that, there's stuff like I buy my butter at Costco, and butters apparently gone up by some meaningful amount. I don't know, 5% or 10%.

According to Statistics Canada, there's a non-government agency, no, not an agency, a company organization that they're scraping web data to do their own pricing index for food and their claim is that butter is up more like 20%, but I buy my butter at Costco and it hasn't changed in price over the last year. I buy my meat from a farm directly. Again, their prices have not gone up in the last year. So I think even-

Cameron Passmore: Really?

Ben Felix: Yeah. Well, the prices might go up because there might be some feed shortages. They haven't seen that yet, but throughout the summer, the cattle are grazing in pasture, right? So there's not a big cost increase.

Cameron Passmore: Have you bought beef in a store lately?

Ben Felix: I don't, but, yeah, I get it. So I'm just saying, though, that even based on Statistics Canada's estimates, even getting more into the weeds on my personal situation, I think 3.1% is probably an overstatement. I know you looked at it, too. What was your personal inflation rate?

Cameron Passmore: I was four. So I think the big difference between your household and mine, I think we have more in electronics, communications, and insurance with more vehicles, less on food, way, way less on food than you guys. That's what I surprised here you so much. I thought the food would've pulled you up a lot more.

Ben Felix: So I think that's big and it gets even more interesting because somebody actually in The Rational Reminder community pointed me to this research from a German researcher and she's looked at the lasting impact of inflation experiences on people's perception of inflation. She finds that every individual person is going to have different inflation expectations based on their life experiences. So she's got a 2013 paper, which was, as I understand, a pretty important paper, and the paper's titled Learning From Inflation Experiences.

So she and some co-authors find that differences in lifetime experiences strongly predict differences in subjective inflation expectations. So it's like if you're born in a cohort of people who lived through a period of high inflation, your expectations for future inflation are going to be higher than some-

Cameron Passmore: Wow.

Ben Felix: Yeah. Right. So yeah. It's a generational or a cohort effect where people who have lived through periods of high inflation are going to have higher inflation expectations. They have another paper because that could be due to whatever biases or whatever. So they have another paper where they looked at members of the federal reserve open market committee. So these are people who are as close as it gets to inflation data and to understanding responses to inflation and all that stuff. They found the same effect to be true. So the same cohort effect based on when you were born and what inflation regimes you've lived through influences your inflation expectations. Crazy, right?

So they had another paper where they went into, I guess, even more detail. So they looked at the exposure to grocery prices and inflation expectations. This one was fascinating, especially considering what we just talked about about specific grocery items that you're buying. So they found that consumers rely on the price changes of goods in their personal grocery bundle when forming expectations about aggregate inflation. So people aren't thinking about their personal inflation. They're thinking about aggregate inflation and they might be making financial decisions based on that, but what influences that, what influences your aggregate inflation expectations are the frequency of purchase and positive sign of price changes.

So I mentioned butter. If you buy butter every week and butter increases in price, that's going to have a bigger impact on your inflation expectations than some other thing that's more important to you, that's more important in terms of weight in your inflation basket but you don't purchase as frequently. So once stuff that people buy frequently goes up in price, they increase their inflation expectations, even if that frequently purchase thing is not a big part of their consumption basket.

Cameron Passmore: Like gas for your car, for example.

Ben Felix: Yeah. So they mentioned gas. I don't remember if gas was in a paper or I listened to this researcher on a podcast, too, but they talk about gas, too, because you always see the price of gas. So yeah, that's another big one that can inform inflation expectations, but the interesting thing is that it forms expectations about aggregate inflation. You don't think, "My stuff is getting more expensive." You think, "Oh, no, inflation, as a broader concept, is going to be high in the future."

Now, this is important because it actually influences financial decisions that people make. So in learning from inflation expectations, they found that the biased estimates that people have about inflation based on their personal lived experience can explain household borrowing and investing behavior. So households with higher experience-based inflation estimates are more likely than other individuals to borrow using fixed rate mortgages, and they're less likely to invest in long-term nominal bonds.

So it's pretty interesting, and I think you could probably extrapolate that other perceived inflation hedges might be more likely to be allocated to by people that have these higher subjective inflation expectations.

So we talked about your personal consumption basket. Not the headline inflation, the reported inflation is what matters when it comes to the impact of price increases on your consumption, but the stuff that you buy most frequently in that basket is likely to have the biggest impact on your expectations for aggregate inflation, which might influence your asset allocation decisions, which doesn't make sense because you are biased as we just talked about, your biased view on where inflation is going based on the stuff that you buy most often is probably not a very useful proxy for actual expected inflation.

So I think people have to understand how their consumption basket is different from average, but I think you've also got to understand how your inflation expectations based on past inflation that you've lived through, but also based on what you buy most frequently, I think people have to understand that as well. We see this in The Rational Reminder community, too, where people are talking about and actually making asset allocation decisions based on inflation expectations. This is a real thing, but even that, so even refining your personal consumption basket to measure your personal inflation and adjusting your estimates based on the biases that you may have, even doing those things doesn't tell the whole story.

One of the other big challenges with an aggregate consumer price index, so we talked with the 4.7% CPI, it doesn't account for substitution. Likewise, for my individual basket, so I found my personal inflation was 3.1%, but that number also doesn't account for substitution. So what's substitution? Well, when beef gets more expensive, like we talked about earlier, which it did in October '21, beef jumped up a lot in price, people might buy fish instead and fish over this time period did not really increased in price, at least not as much.

I even saw people on Reddit talking about inflation, same kind of thing like, "Oh, beef is so expensive," and people are talking about how they tried tofu for the first time. That's substitution and people will do it. They're not just going to keep their heads down and keep spending the same on their consumption basket that they would have otherwise.

Cameron Passmore: That is so interesting. I never thought of it that way. It may be a real number, but it's not like taking into account change that you've made in your decision pattern.

Ben Felix: Correct, and then that's only one of them. So that's product substitution. I think it's called commodity substitution is the formal term for it, but the other one is outlet substitution. So in my notes, I put the example of if someone usually shops at Whole Foods, they might start going to no frills. I saw this, too, actually on Reddit, people talking about inflation and people were talking about how they went from whatever, going to one store to no frills and how much cheaper various items were at no frills.

So those are two upward biases in the CPI or in any inflation index. Even in your own personal basket, I think you have to account for substitution, which likely people would do. There's actually a paper I found from the Bank of Canada, and it's an interesting dynamic to observe, too.

So Statistics Canada comes out with an estimate. The Bank of Canada has to make policy decisions based on the Statistics Canada estimate, but the Bank of Canada actually makes these corrections to the Statistics Canada number so that they have a better estimate of the cost of living changes and Bank of Canada's going to base their policy decisions on that, not on the raw number from Statistics Canada.

So this 2012 paper that I found from the Bank of Canada is looking at the biases that I just mentioned, commodity substitution and outlet substitution, but they're also looking at biases related to new goods that are not immediately included in the CPI basket and adjustments for the quality of goods in the basket. They found between all those different biases there is an upward bias between 0.45% and 0.6% per year in the CPI estimate compared to the actual cost of living for a Canadian. It's pretty meaningful, right?

So to state it another way, CPI is a measure of aggregate inflation systematically overestimates the actual cost of living increase at their representative household experiences. I thought that was pretty important.

Now, another big one, and this comes from a couple of our podcast guests, retirees or people living on fixed incomes or people with high bond allocations that are retired or close to retirement, they're often cited as the ones most exposed to inflation. I hear that all the time. That assumption completely falls apart under scrutiny. This is a pretty well-documented phenomenon known as the retirement consumption puzzle, and that is the empirical observation that inflation adjusted retiree expenditures tend to decrease both upon and during retirement.

So we do this, too. We, we plan for consumption increasing with inflation and the argument, and I think my hunch is that telling people that we're not going to do that, we're going to assume you don't increase your expenses with inflation, that would make people nervous. I think planning to keep pace with inflation is comforting and it's the conservative thing to do, but it's also at odds with the empirical evidence.

So empirically, the decrease in real consumption for retirees average is about 1% per year during retirement. So that means if inflation was 3% in a given year, retirement consumption would tend to increase. So still increasing, but only by 2%. So inflation's up 3%, retirement consumption is up 2%. So there's that 1% lag in real consumption per year, though. So stuff's getting more expensive still for people who are retired, but their total real consumption is decreasing.

So David Blanchett, guest in episode 137, he had a paper in the Journal of Financial Planning exploring the retirement consumption puzzle. He shows that there is an increase later in life. So that's why he calls it retirement spending smile, which we talk to him on the podcast, but keeping in mind that we're here in Canada. That spike in consumption later in life that Blanchett finds is largely related to healthcare expenses. We probably wouldn't have the same experience in Canada. So you see this decreasing real consumption over time.

Then Fred Vettese, we also talked to him about this. He's, of course, a retired actuary, an author of a bunch of books on retirement. He told us when he was a guest on episode 104 that based on ... He didn't name the studies. I could probably ask him or it's maybe in his book, but I think he named three different studies all from Europe, but based on those studies and his own experiences, he says retirees should plan for consumption that's growing with inflation in their 60s, inflation minus 1% in their 70s, and inflation minus 2% in their 80s. So pretty interesting.

Then I think the other big one that, again, often gets overlooked in the inflation panicking is that for retirees specifically, government benefits like Canada pension plan, CPP, and OAS, old age security, make up a portion of most people's retirement assets. So people often don't think about those as assets, but they are. So somebody might have investments, but most Canadians are still going to have some amount of CPP and OAS, and these are indexed to CPI, to the CPI all items index, which is an index that as we just mentioned a minute ago, probably provides an upward biased estimate in the cost of living. So that's interesting, too.

See, take all that stuff together, empirical evidence of declining, real consumption through retirement, got an upward bias inflation index pension asset in Canada pension plan and old age security. I don't know if inflation is ... I'm not saying inflation's a good thing. Don't get me wrong here. There's an empirical fact, and there's a bit of a cushion in CPP and OAS that dampens the blow at least, not to mention the other stuff that we talked about like substitution.

So I think the tile of that together, the effects of inflation on individual investor's consumption is complicated. The other worry that comes up with inflation that I alluded to at the beginning is the impact on financial assets. So I think for a second we've got to take a step back and talk about the pricing of financial assets for a moment. The price of a financial asset is theoretically the present value of expected cash flows discounted at some rate, and the discount rate describes the riskiness of the cash flows. Most people listen to this podcast have heard that in terms of finance's pretty basic theory, but you can actually decompose the discount rate into multiple components.

This is stuff that goes back to research from early Fama days, probably even before then. I haven't done as much reading pre-Fama. So for a stock, the discount rate theoretically decomposes into a risk-free real rate expected inflation in the discount rate. There's a term for expected inflation, a risk premium for the uncertainty about future inflation. So there we've got a real risk-free rate, expected inflation, an inflation risk premium, and a risk premium for owning stocks instead of bonds or bills.

Bonds have a similar discount rate decomposition, but the risk premium is going to be different, obviously, because you're not owning a stock in that case. So if it's a corporate bond, you're going to have a credit risk premium, might be a term risk premium, but in all cases, the important point that I'm making here is it in those discount rates, there is an inflation expectation. So I think that's pretty important.

So expected inflation, the inflation that the market expects, is in prices. So if we get the inflation that is expected, you expect to be compensated for it by owning stocks or or bonds. It's unexpected inflation that causes a problem for asset prices. There's a pretty deep body of literature on this relationship, Fama and Short of a 1977 paper on that topic. Fama's got a 1981 paper, and Buddock and Richardson have a 1993 paper. They all formalized this negative relationship between asset prices and inflation. So it's kind of accepted as fact.

Dimson, Marsh, and Staunton, I always love cross-referencing other findings with their stuff just because they have their unique data set. So they document the same relationship for 21 countries back in 1900 and they showed that high inflation has been negative for real stock returns and long bonds have been impacted more dramatically than stocks when inflation is very high. In deflationary periods, bonds have outperformed stocks by a wide margin.

So if we could predict a deflationary period, we would rather hold bonds. In high inflation, bonds do worse than stocks, but stocks also have relatively poor performance. So I mean, the intuition on why does this happen is pretty straightforward, I think. We just talked about discount rate. So the discount rate for a nominal bond includes an inflation expectation and then inflation risk premium. If inflation expectations or inflation uncertainty increase, bond prices should fall and longer data bonds are going to be more sensitive to changes in the discount rate in terms of their price.

So I think for bonds, they're pretty straightforward. Their cash flows are more certain, fixed income. That's all pretty easy to think about. The mechanism for stocks, as usual, is a little bit more complicated. The discount rate is still affected. So if inflation expectations go up, discount rates for stocks go up, prices go down, but cash flows can also be affected by inflation expectations.

So that makes it a little bit messier of a relationship, but empirically, we know stock performance decreases. Stocks don't do as well under inflation. So because stocks tend to perform poorly under high inflation, like I mentioned earlier, they're definitely not an inflation hedge. They do deliver that risk premium or they're expected to deliver the real risk premium above inflation, but in the short run, they're certainly not an inflation hedge, and then longer dated bonds or even intermediate bonds, not so good in inflation. Short dated bonds, and we talked about this in a previous episode, if you're holding one month bills and rolling them over, historically, that has offered some inflation protection as central banks raise rates to combat inflation. If they take that action, then short term bills prices aren't really going to be affected because they have such short maturities, but you'll be able to roll them over at higher yields, which historically been protective in inflationary periods.

So the big question, though, that people start asking is if stocks and bonds don't offer protection in high inflation periods and they may even take a hit, should we be adding other stuff to the portfolio? If there was an asset that tends to increase in price when inflation is high, that seems like it'd be a pretty good asset to add to a portfolio if you're worried about inflation, but that asset is unfortunately pretty elusive.

There's a 2021 paper, US inflation and global asset returns, I thought it was a pretty thoughtful paper. It's a working paper, not published. So they look at the relationship between US inflation and the performance of global assets, including bonds, stocks, stock industry portfolios, factor risk premiums. They looked at size, value or they looked at premiums. They also looked at style portfolio, so like the value premium, the size premium, but also the small cap value long only portfolio and the value long only portfolio. They looked at commodities and they looked at REITs over the period 1927 to 2020 for most asset classes and 1991 to 2020 for all of the asset classes that I just mentioned.

One of the interesting things they find is that in their samples the average real returns are lower in years with higher inflation for most of the assets they look at, but the differences are not statistically reliable, especially in the more recent sample, and despite the lower returns, so not statistically reliable but still lower, despite the lower returns, most assets still have positive average returns in the high inflation years. The assets they found that did have positive correlations with expected and unexpected inflation in the post 1991 sample were energy stocks and commodities.

So I think people have probably heard of those assets being a potential inflation hedge, but they found that the volatility of those assets would've made them poor inflation hedges. Energy stocks and commodities had returns that were about 20 times as volatile as inflation and more than half of their return variance is not explained by inflation. So to the extent that an inflation hedge is designed to reduce the uncertainty of real consumption, which I think that's what you're trying to get out of it, the high volatility of commodities and energy stocks makes them pretty unsuitable.

So they do have a positive relationship with inflation. They tend to do well when inflation is high, but they're much more volatile, and a big portion of that volatility is unrelated to inflation.

Cameron Passmore: Isn't that interesting?

Ben Felix: Yup. So the style portfolios, value and small cap value, they did have lower returns under high inflation than under low inflation. So you're better off owning value in small cap value portfolio when inflation was low than when it was high, but the thing that I found interesting here is that they still delivered meaningfully positive access returns compared to the market in periods of high inflation. So the average annual US market return under high inflation from 1927 to 2020 was 5.71%, while the small cap value portfolio under high inflation was 11.95%, and the large cap value portfolio was 8.13%. So you still had access returns compared to the market if you're allocating to the value in small cap value portfolios.

REITs were another one in the 1991 to 2020 sample. Emerging markets, too. They're not inflation hedges because they don't have the correlation with inflation that commodities or energy stocks have, but I think the takeaway that I had looking at the data in this paper is that even if you don't have the perfect inflation hedge in a portfolio, a portfolio that's diversified across multiple sources of expected return is going to be more resilient in periods of high domestic inflation.

Last time we covered inflation as a topic, there was a paper looking at international equities as an inflation hedge. I think it's the same idea. The more independent risk premiums you can add to a portfolio, the more resilient your expected returns are going to be even if you have high domestic inflation.

Cameron Passmore: Which you would expect to outperform inflation, but you just can't call it a hedge.

Ben Felix: Correct. You expect a long run risk premium. You're going to have a more reliable outcome if you have more sources of expected return. I didn't mention that with commodities. The other issue with them is that they outside of high inflation periods, historically, the return has been really low. All of those other assets that we just mentioned, while they don't provide that inflation hedging property in the sense that they're not correlated with inflation, but they've all had positive returns outside of inflationary periods. Whereas commodities, you get these spikes in returns when inflation's high, but outside of it, you have low or negative real returns.

Then I wanted to touch on one more aspect of commodities. I find commodities to be interesting. Correlations are unstable. People generally get that. You don't want to look at past correlations and assume that they're going to continue in the future. Those relationships can be very non-stationary.

There's a paper, inflation hedging in the long run practical perspectives from seven centuries of commodity prices. The authors investigate the inflation hedging ability of 50 commodities for 80 countries and seven centuries of data. I thought that was just an interesting perspective. In the paper, they do actually say that in their view, you should have some commodities in your portfolio, but I took their result differently, and I'll explain why.

So they do confirm that commodities have had a positive correlation with inflation, particularly over longer horizons of years or decades, but they find that the inflation hedging capacity of commodities has changed over time. So agricultural commodities offered protection until the beginning of the 19th century and then coincident with the start of the industrial revolution, energy and industrial commodities offered greater protection. Then more recently, energy commodities offered the greatest level protection during in the second half of the 20th century.

So the optimal inflation hedging commodity basket has been different throughout time. I think if you think about like, "Okay. So energy commodities have recently been the best inflation hedge," but you got to wonder just with the increase and uptake of electric vehicles and the hope for decrease in reliance on fossil fuels, you got to wonder if energy commodities will continue to be the best inflation hedge for the next 50 years. I don't have the answer, of course. Just posing it as a point of interest.

So the other thing, so there's variation in hedging capacity over time for different commodity baskets, but it also differs across regions. So to get the highest level of protection from commodities as an inflation hedge, not only do you have to pick the right commodity basket at the right time, but you've got to pick the right commodity basket at the right time for your region, which is going to differ from region to region.

Now, I think an aggregate commodity baskets still offers some inflation protection, but the point is that that optimal inflation hedge, it's not commodities. It's like a commodity basket. I don't know if we could predict which one. Then, of course, like I mentioned before, the expected returns outside of high inflation periods are super low, which is problematic. So like we concluded last time that we talked about a somewhat similar topic. I don't really think people need to look any further than a properly diversified portfolio of stocks and bonds with, of course, exposure to multiple sources of expected return.

I didn't touch on it too much, but the other side of value doing well relative to the market in high inflation periods, growth didn't so well, and that's not a statistically reliable relationship, but it shows up in the data. That's it.

Cameron Passmore: Excellent. Ready for some talking sense cards?

Ben Felix: Ready?

Cameron Passmore: All right. So this is from the University of Chicago's financial education initiative. As you said earlier, available in our online store. Okay. Imagine you have reached your financial dreams. What words would people use to describe you? So I'll give you a break and go first. So as we've said many times before, and Dr. Moira Somers talked about this, how more money makes you more of who you are. So if I reached my financial dreams, I would hope that people describe me pretty much the same way as I was always, perhaps a little more time on my hands, perhaps more free family time, perhaps relaxed. Although I think I'm reasonably relaxed now. What words would people use to describe you if you've reached your financial dreams?

Ben Felix: I don't know what my financial dreams are.

Cameron Passmore: I knew you were going to say that.

Ben Felix: I don't. I mean, would I love to have a big pile of money? Sure, but I wouldn't say it's a dream. I don't dream about it. I don't have a good answer.

Cameron Passmore: I don't see either of us changing a whole lot. It's not like a sign goes up and says, "Okay. You've made it and now you're going to behave differently." I don't know how we would do that.

Ben Felix: I would hope, it's like what you said, I would hope that people would describe me the same way that they describe me now if I had the bunch of money. I think it would be a problem, I think, if I would expect to be a different person after reaching the-

Cameron Passmore: Totally.

Ben Felix: Maybe that's why I don't have financial dreams.

Cameron Passmore: Next one, an old saying goes, "A bird in the hand is worth two in the bush." What do you think this means?

Ben Felix: Well, if you have something you're not taking risk, I think. If you have a bird, you're not taking risk. If there are two birds in the bush, you have to take some risk to try and acquire them, and there's a chance you get no birds.

Cameron Passmore: Don't be greedy, but you could also think about it long term, though. Two in the bush could be doubling your money with compounding as opposed to consuming it today. You could consume twice as much tomorrow. It's like that marshmallow experiment with the kids, right?

Ben Felix: Yeah, but the birds are in a bush, though.

Cameron Passmore: So go the other way, which is don't be greedy today.

Ben Felix: When you read it, of course, I've heard this saying before, when you're reading it, my brain was saying liquidity premium. I don't know. That's where my brain went, but then you think about it. These birds are in a bush. You're not locking them up in an illiquid asset. You don't know if you're going to get them back. They're in a bush. What are you going to do? If I'm holding a bird in my hand, that bird's mine. I couldn't go catch two birds right now. I couldn't go catch one bird right now. I could not walk outside. There are birds outside my house. I could not go and catch one.

Cameron Passmore: So it's a risk management story from your perspective, not a compounding asset story.

Ben Felix: I don't think birds are going to compound unless they're going to mate, I guess, and maybe then I can go. At some point, there are so many birds that it's easy to catch them. I don't know.

Cameron Passmore: Oh, my God! Do you want one more?

Ben Felix: Sure.

Cameron Passmore: I pull this one to random. Think about a time when you made a decision that didn't turn out well. What did you learn?

Ben Felix: Oh, jeez!

Cameron Passmore: Think about this time you made a decision that didn't turn out well. What did you learn? I can't think about one.

Ben Felix: Jeez!

Cameron Passmore: We're both stumped.

Ben Felix: Yeah. That's a really tough question.

Cameron Passmore: I guess that's the point of these cards. Really make you think.

Ben Felix: Does that mean that we don't learn from our mistakes or does it mean that we don't make-

Cameron Passmore: Poor decisions or I don't know what it means. Maybe it's just too much pressure to think about it.

Ben Felix: Oh, jeez. Yeah. I got nothing.

Cameron Passmore: I'm just thinking. I mean, I think we're pretty good here at work about learning from decisions that we may have made that didn't turn out great. We just learned from it and changed the process going forward. Lately, I think we've learned a lot about learning from other people's experiences. So not that we made a poor decision, but sometimes I think I would've had more confidence in my decision.

For example, you asked me what I thought about a website you saw and you thought I didn't like it. That's not true. I was more ambivalent. I'd rather see the data about whether or not the website is going to work the way we want it to work as opposed to passing judgment right away. So I'm becoming perhaps less certain about my judgment on certain things and more respectful of other people's opinions into it, and especially the data into something. These cards work. They made us think.

Ben Felix: I got one. Early in my career of working, I took a job working for someone and that job didn't work out. I think I learned about just doing due diligence on people. That's a lesson that I've probably carried with me since then. If you're going to get involved with a person professionally, but I guess otherwise too, understanding who they are and what their motivations are, and even what history is I think is something that's pretty important.

Cameron Passmore: It's a good answer. Three good cards. Okay. That's a wrap.

Ben Felix: That's it.

Book From Today’s Episode:

Working Backwards: Insights, Stories, and Secrets from Inside Amazon — https://amzn.to/2ZD3MIs

Links From Today’s Episode:

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/ 

Shop Merch — https://shop.rationalreminder.ca/

Join the Community — https://community.rationalreminder.ca/

Follow us on Twitter — https://twitter.com/RationalRemind

Follow us on Instagram — @rationalreminder

Benjamin on Twitter — https://twitter.com/benjaminwfelix

Cameron on Twitter — https://twitter.com/CameronPassmore

'Learning from Inflation Experiences' — https://academic.oup.com/qje/article-abstract/131/1/53/2461168

'Inflation Hedging in the Long Run' — https://jai.pm-research.com/content/early/2021/05/22/jai.2021.1.136