Mar 11, 2009
Is cash (that is, short-term riskless bonds) a safe investment if we think about future consumption and not about nominal dollars?

EFF/KRF: Short-term high grade bonds are a good hedge against inflation. If hedging inflation is your overriding goal, short-term high grade bonds are the route for you. (Gene has been saying this for about 40 years.) But don't expect much in the way of a real return. Short-term bonds maintain purchasing power, but they don't enhance it, since the real returns they produce are quite low (for example, less than %1 per year on T-bills). In other words, if you don't take much real risk, you can't expect much real return.

In contrast, long-term nominal bonds are terrible inflation hedges. For example, the current yield on the ten-year government bond is 2.82% and yields on longer-term governments are also quite low. This reflects a forecast that inflation is likely to be quite low even long-term. If inflation - and expected inflation - turn out to be higher than forecast, interest rates will rise and longer-term bonds will suffer capital losses. The capital losses and the reduction in purchasing power are a double whammy to future consumption. In short, long-term bonds may be risk-free in nominal terms but they pose serious hazards to your long-term consumption.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.