- TIPS are designed to be a hedge against rising interest rates by taking into account the current rate of inflation.
- Over the long term, stocks have earned investors an average annual return of 7%.
- Since TIPS were introduced in the ‘90s, they have earned investors an average annual return of 4%.
What is the difference between investing in Treasury Inflation-Protected Securities (TIPS) versus the stock market? TIPS are indexed with inflation, meaning they are better investments than traditional bonds — but only if inflation rises. They tend to perform best when the economy isn’t going well. However, if inflation drops, 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 stock market’s historical performance. To understand TIPS in light of the current economic environment, we will compare the two during periods with rising interest rates and examine how they cope with inflation. This data will give you the knowledge and perspective needed to choose where and how to invest your money.
How TIPS work
In order to compare TIPS against the stock market, you must first understand how TIPS work. They operate like traditional bonds because they have a fixed coupon rate that the bond pays until maturity. However, their face value changes based on inflation and the U.S. Consumer Price Index (CPI).
For example, if you purchase a 10-year TIPS with a 3% coupon rate and a $1,000 face value, you will earn that 3% annually for the entire 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.
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Since the interest relates to the face value of the TIPS, the 3% coupon you earn is now $31.50. With a traditional bond, the face value would stay at $1,000, and the 3% coupon would earn you $30 annually.
Historical performance of TIPS
TIPS have been around since the late 1990s, and they have performed well during that time. But they haven’t offered far superior returns compared to other types of fixed-income securities. For example, from 2002 through 2021, U.S. bonds returned 4.33%, and global bonds returned 4.43%. Since 2000, the Vanguard TIPS fund (VIPSX) has returned 4.83%.
For TIPS to significantly outperform other fixed-income securities, inflation needs to be much higher than what the market experts estimate it will be.
TIPS protect people against increases in inflation; hence, they should be a compliment to other bonds, not a full-scale replacement.
TIPS performance during periods with rising interest rates
Since the introduction of TIPS, there have not been many instances 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 during 2008, we get mixed signals.
One would think that during this time of rising interest rates TIPS would outperform the market — but they didn’t. There are many reasons for this, including the fall of Lehman Brothers, which was the largest holder of TIPS, and had to sell quickly as the firm went out of business. With this flood of supply, along with the fear of economic chaos, prices dropped. As a result, overall returns on TIPS fell.
If we take out the anomaly that was 2008 and the fall of Lehman Brothers, how do TIPS perform during rising interest rate environments? As interest rates go up, TIPS payments should also go up. Additionally, as the CPI 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 consider TIPS low risk because the U.S. government backs them, and 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 performance of the stock market
The historical average return of the stock market is 10%. However, this does not account for inflation. Considering the average inflation rate of 3%, investors can expect to earn roughly 7% annually by investing in the stock market.
You must also remember that this is an average, and performance of the market as a whole can vary wildly from year to year, month to month, and minute to minute. There are no guarantees you will make money in any given period.
Stock market investors are best served when they’re in it for the long term. They invest in stocks with money they intend to keep tied up for at least five or ten years because of the aforementioned variability. You’re much less likely to lose money over a ten-year period than a two-year period.
If your investing time horizon is less than five years, you are better off choosing a lower-risk option. You might opt for short-term bonds or even an online savings account.
Stock market performance during rising interest rates
When interest rates rise, it hurts the stock market (and subsequently your earnings) because investors can invest in less risky assets and get a comparable return. For example, a stock might return 7% a year. But with rising interest rates, a short-term bond might pay 5%. There is considerably less risk of losing money in the bond, so some investors opt for this safety of the bond over stocks’ volatility. When this happens on a larger scale, the stock market declines since there is less demand for stocks.
Additionally, when rates rise, it costs businesses more to borrow money. Some may opt to charge more for their products to offset this increase. When the cost of living increases, people have less money to invest, lowering demand.
When interest rates drop, the reverse is true. Investors will buy more stocks because they return a more significant amount, and there is more money to invest overall. Companies can borrow at low interest rates to expand their businesses, making their prospects for growth all the more rosy in the eyes of potential investors.
TIPS vs. inflation
With TIPS, you have protection against rising inflation because of the direct link with inflation levels. If inflation increases, the payments you will receive from your TIPS will rise accordingly. The payments usually come twice per year, and each time, changes are made to adjust for inflation.
If you want to buffer your finances against rising inflation rates, TIPS are a particularly effective and straightforward option. However, this can be more complicated if you invest in mutual funds or exchange-traded funds (ETFs) that include TIPS because the fund’s price is what the market thinks it is worth, not necessarily the face value of the bond. As a result, you might not earn the inflation-adjusted amount you planned.
Stocks vs. inflation
The higher inflation gets, the more volatile the stock market becomes. You need to 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 constant and sustained rise in the level of prices, and if prices keep going up, a crash has to be on the horizon. Prices cannot rise indefinitely, so high inflation levels are often associated with the risk of recession and an unstable economy.
By contrast, low inflation rates are associated with growth and tend to make the stock market safer and more stable. However, the relationship between the two isn’t 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 significantly changing, the dollar is retaining its value, and the economy is reasonably stable.
When inflation is higher than this, consumers have reduced buying power, and their money has less value, which results in higher costs for everyone, including businesses. This creates uncertainty, reduces investment in the stock market, and makes everything riskier.
The bottom line
Choosing whether to invest in the stock market or TIPS can be enormously challenging and depends on many factors unique to your financial situation. If you have money that you can lock up for the long term and are comfortable with the risks associated with stocks, the stock market might be the more attractive option. However, TIPS may be a more popular choice for those who are investing for a shorter duration or are risk-averse.
With that said, a diversified portfolio made up of stocks and bonds is in the best interest of most investors over the long haul. Getting your allocation right from the start increases your odds 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 investing goals or time horizon. Best of all with Q.ai, you can activate Portfolio Protection at any time to protect your gains and reduce your losses, no matter what industry you invest in.
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