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key takeaways
TIPS are designed to hedge against rising interest rates by taking into account the current rate of inflation. Over the long term, stocks have given investors an average annual return of 7%. Since TIPS were introduced in the 1990s, they have generated an average annual return of 4% for investors.
What is the difference between investing in Treasury Inflation-Protected Securities (TIPS) and the stock market? TIPS are indexed to inflation, which means they are better investments than traditional bonds, but only if inflation rises. They tend to perform better when the economy is not doing well. However, if inflation falls, they will underperform other options and be more volatile than cash.
In this article, we will explore the historical performance of TIPS and contrast it with the historical performance of the stock market. To understand TIPS in light of the current economic environment, we’ll compare the two over periods of rising interest rates and examine how they cope with inflation. This data will give you the insight and perspective you need to choose where and how to invest your money.
How TIPS work
To compare TIPS to the stock market, you must first understand how TIPS work. They work like traditional bonds because they have a fixed coupon rate that pays off the bond until maturity. However, its face value changes based on inflation and the US Consumer Price Index (CPI).
For example, if you buy 10-year TIPS with a 3% coupon rate and $1,000 face value, you’ll earn that 3% per year for the full 10 years if inflation remains stagnant. If inflation increases to 5% the following year, the face value of the TIPS bond will increase to $1,050.
Since the interest is related to the face value of the TIPS, the 3% coupon you earn now is $31.50. With a traditional bond, the face value would remain $1,000 and the 3% coupon would earn you $30 a year.
Historical performance of TIPS
TIPS have been around since the late 1990s and have done well during that time. But they have not offered much better returns compared to other types of fixed income securities. For example, from 2002 to 2021, US bonds returned 4.33% and global bonds 4.43%. Since 2000, the Vanguard TIPS (VIPSX) fund has returned 4.83%.
For TIPS to significantly outperform other fixed income securities, inflation needs to be much higher than market experts estimate.
TIPS protect people against increases in inflation; therefore, they should be a complement to other bonds, not a full-scale replacement.
Evolution of TIPS during periods with rising interest rates
Since the introduction of TIPS, there have not been many cases of rising interest rates. Aside from the Great Recession in 2008, interest rates have been at or below 3%. And when we look at how TIPS performed in 2008, we get mixed signals.
One would think that during this time of rising interest rates, TIPS would outperform the market, but they did not. There are many reasons for this, including the fall of Lehman Brothers, which was the largest holder of TIPS, and had to sell quickly when the company went out of business. With this rush of supply, coupled with fears of economic chaos, prices fell. As a result, overall TIPS yields fell.
If we remove the anomaly that was 2008 and the Lehman Brothers crash, how do TIPS fare in rising interest rate environments? As interest rates rise, TIPS payments should also rise. Also, as the IPC remains high, the face value of TIPS increases in value.
Because of this, more people have started paying attention to TIPS in recent years because they offer protection against rising interest rates.
Investors view TIPS as low risk because the US government supports them and a default is unlikely. However, if inflation changes to deflation, TIPS would adjust accordingly and become less valuable, so there is still some risk involved.
Historical Stock Market Performance
The historical average profitability of the stock market is 10%. However, this does not take into account inflation. Taking into account the average inflation rate of 3%, investors can expect to earn approximately 7% per year when investing in the stock market.
You should also remember that this is an average and the performance of the market as a whole can vary greatly from year to year, month to month and minute to minute. There are no guarantees that you will earn any money in any given period.
Stock market investors are best served when they are in it for the long haul. They invest in stocks with money that they intend to keep immobilized for at least five or ten years due to the aforementioned variability. You are much less likely to lose money over a ten-year period than you are over a two-year period.
If your investment time horizon is less than five years, you’re better off choosing a lower-risk option. You can opt for short-term bonuses or even an online savings account.
Stock Market Performance During Rising Interest Rates
When interest rates rise, it hurts the stock market (and therefore your earnings) because investors can invest in less risky assets and earn a comparable return. For example, a stock might have a return of 7% per year. But with interest rates rising, a short-term bond might pay 5%. There is considerably less risk of losing money on the bond, so some investors choose this bond security over stock volatility. When this happens on a larger scale, the stock market falls because there is less demand for the stock.
Also, when rates go up, it makes it harder for businesses to borrow money. Some may choose to charge more for their products to offset this increase. When the cost of living increases, people have less money to invest, which reduces demand.
When interest rates go down, the opposite happens. Investors will buy more shares because they return a more significant amount and there is generally more money to invest. Companies can borrow at low interest rates to expand their businesses, making their growth prospects even more rosy in the eyes of potential investors.
TIPS vs. inflation
With TIPS, you have protection against rising inflation due to the direct link to inflation levels. If inflation increases, the payments you will receive from your TIPS will increase accordingly. Payments are generally made twice a year and each time changes are made to adjust for inflation.
If you want to protect your finances against rising inflation rates, TIPS are a particularly effective and easy option. However, this can be more complicated if you invest in mutual funds or exchange-traded funds (ETFs) that include TIPS because the price of the fund is what the market thinks it is worth, not necessarily the face value of the bond. As a result, you may not earn the inflation-adjusted amount you planned for.
Actions vs. inflation
The higher inflation is, the more volatile the stock market becomes. You should choose your stocks much more carefully in a high-inflation market than in a low-inflation market, as the risk is more significant.
Remember that inflation is simply a steady and sustained rise in the price level, and if prices continue to rise, there has to be a fall on the horizon. Prices cannot rise indefinitely, so high levels of inflation are often associated with recession risk and an unstable economy.
In contrast, low rates of inflation are associated with growth and tend to make the stock market safer and more stable. However, the relationship between the two is not always straightforward and is often complicated by geopolitical variables.
Ideally, inflation levels should be around 2-3% for the stock market to thrive. This rate means that prices are not changing significantly, the dollar retains its value, and the economy is reasonably stable.
When inflation is higher than this, consumers have reduced purchasing power and their money has less value, resulting in higher costs for everyone, including businesses. This creates uncertainty, reduces investment in the stock market and makes everything more risky.
The bottom line
Choosing whether to invest in the stock market or TIPS can be challenging and depends on many factors unique to your financial situation. If you have money that you can secure for the long term and you’re comfortable with the risks associated with stocks, the stock market might be the most attractive option. However, TIPS may be a more popular option for those who invest for a shorter duration or are risk averse.
That said, a diversified portfolio made up of stocks and bonds is best for most long-term investors. Getting your assignment right from the start increases your chances of successful long-term results.
This is where Q.ai comes in. They have investment kits to help you build your ideal portfolio, no matter your investment goals or time horizon. Best of all with Q.ai, you can activate Portfolio Protection at any time to protect your profits and reduce your losses, no matter what industry you invest in.
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Source: www.forbes.com