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How Do Investors Respond to Inflation?

Individual investors struggle to react appropriately

Fabio Braggion / Felix von Meyerinck / Nic Schaub - January 20, 2022

Tips for practitioners

Inflation is among the most significant economic risks faced by individuals. Following the outbreak of the COVID-19 pandemic, inflation resurfaced in developed countries. In Germany, for example, annual inflation surpassed 5 percent in November for the first time in nearly three decades. Thus, individuals have to think about how to respond to rising inflation.

Holding money on a checking or savings account is not a good idea during inflationary periods

Leaving money in a checking or savings account is typically not an option during inflationary periods. This is particularly true today as checking and savings account holdings yield (close to) zero interest. Because of low interest rates, money left in these accounts continuously loses value in real terms during inflationary periods. That is, 100 euros in one year will buy fewer goods and services compared to 100 euros today. Thus, individuals must think about alternatives to preserve the real value of their financial wealth.

One potential way to hedge against inflation is investing in equities, either directly by purchasing individual stocks or indirectly by buying equity funds, such as exchange-traded funds (ETFs). However, little is known about how investors respond to the prospect of higher inflation.

Theory provides conflicting predictions on investors’ response to inflation

There are two main theories on investors’ response to inflation. On the one hand, the so-called hedging hypothesis predicts that investors are more likely to buy and less likely to sell stocks when expected inflation increases. This is because investors understand that stocks entitle them to a fraction of the income generated by the underlying real assets. Thus, stocks should allow investors to preserve the real value of their investments. In fact, studies provide evidence that inflation and stock returns move together over longer horizons, indicating that stocks offer some compensation for inflation.

On the other hand, the so-called money illusion hypothesis, developed by Nobel laureate Franco Modigliani together with Richard Cohn, suggests that investors are less likely to buy and more likely to sell stocks in periods of higher expected inflation. This is because individuals make valuation errors when pricing stocks during inflationary periods. During inflationary periods, individuals subject to money illusion observe increasing nominal interest rates of fixed-income securities, such as corporate bonds or government bonds. However, they do not understand that dividends of stocks (or nominal cash flows of firms in general) also grow with inflation. As a result, stocks appear less attractive vis-à-vis fixed-income securities for such individuals. Given these two competing hypotheses, understanding how investors react to inflation is an empirical question.

Empirical evidence from Germany in the 1920’s suggests that individual investors were subject to money illusion

A recent working paper by professors Fabio Braggion, Felix von Meyerinck, and Nic Schaub sheds light on the question of how investors respond to inflation by studying trading patterns in Germany in the 1920s, covering the German hyperinflation. This time period provides an ideal laboratory for such an investigation. First, data on investors’ security portfolio holdings and security transactions are available in bank archives. Second, inflation in Germany in the 1920’s was high, potentially yielding large financial losses and thus grabbing investors’ attention. Third, the German Statistical Office provides inflation data at the monthly level for hundreds of towns in Germany in the 1920’s.

The authors collected data on security portfolio holdings and security transactions of more than 2,000 clients of a German bank between 1920 and 1924 and combined these data with the monthly inflation data provided by the statistical office. The authors’ results suggest that individual investors did not understand that stocks offered a hedge against inflation, but they suffered from money illusion. In contrast, professional investors were not subject to money illusion. This study provides the first direct evidence of investors’ response to inflation.

Tips for practitioners

  • Many individuals do not understand that stocks are a claim against the income generated by real assets and thus offer some protection against inflation, at least over longer horizons. Thus, investors should carefully think about equity investments in periods of high inflation.
  • Financial education programs and financial advice should aim at improving the financial literacy of individuals. More specifically, financial education programs and financial advice need to educate individuals on how to protect their financial wealth against inflation.

Literature reference and methodology

In the paper “Inflation and Individual Investors’ Behavior: Evidence from the German Hyperinflation”, researchers Professor Fabio Braggion from Tilburg University, Professor Felix von Meyerinck from the University of St. Gallen, Professor Nic Schaub from WHU – Otto Beisheim School of Management investigate how individual investors respond to inflation. To do so, they use a unique dataset containing information on local inflation and security portfolios of more than 2,000 clients of a German bank between 1920 and 1924, covering the hyperinflation.


Professor Fabio Braggion

Fabio Braggion is a professor of finance and financial history at Tilburg University. He is also a fellow of the Centre for Economic Policy Research (CEPR) and a member of the European Corporate Governance Institute (ECGI). His research interests include financial history, banking, corporate finance, and FinTech.

Professor Felix von Meyerinck

Felix von Meyerinck is an assistant professor of finance at the University of St. Gallen. He is also an affiliated researcher at the Hamburg Financial Research Center. His research mainly focuses on empirical corporate finance and household finance..

Professor Nic Schaub

Nic Schaub is a professor of household finance at WHU – Otto Beisheim School of Management. His research interests are in household finance, behavioral finance, and asset pricing.

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