2002: How do Buffett and Munger consider inflation and deflation in their investment decisions?

AUDIENCE MEMBER: Good afternoon. My name is Bob Baden (PH), from Rochester, New York.

Mr. Munger, this morning, while discussing index funds, you used the example of Japan as a real example of poor performance of a major index over a long period.

Indeed, the S&P 500 index declined over 60 percent, in real terms, from the early ’60s through the mid-’70s.

Could you discuss the mental models you use to consider the impact of inflation or deflation on your investment decisions and the likelihood of either occurring over the next decade?

CHARLIE MUNGER: Well, that’s partly easy and partly tough.

If interest rates are going to go way up, you can obviously have a lot of deflation of stock prices. And a lot of that happened in the American period you’re talking about.

What’s interesting about Japan is that I don’t think anybody thought that a major modern Keynesian democracy, pervaded by a good culture in terms of engineering, product quality, product innovation, and so forth, could have a period where you would have negative returns over 13 years without major depression either.

WARREN BUFFETT: (Inaudible)

CHARLIE MUNGER: I think — and that it would occur while interest rates were going down, not up. I think that was so novel that the models of the past totally failed to predict it.

But I think these anomalies are always very interesting, and I think it’s crazy for Americans to assume that what’s happening in Argentina, what has happened in Japan, are totally inconceivable forever in America. They are not totally inconceivable.

WARREN BUFFETT: You had a huge bubble in equity prices in Japan, and now you’ve had interest rates go to virtually nothing.

You’ve had the passage of time, the country hasn’t disappeared. People are going to work every day, and you’ve had this — the Nikkei, you know, now at a third of what it sold for not that many years ago. It’s an interesting phenomenon.

CHARLIE MUNGER: And huge fiscal stimulus in the whole period from the government.

WARREN BUFFETT: Post-bubble periods, I think, depending on how big the bubble is and how many were participating in it, but post-bubble periods, I think, can produce fallout that not everyone will be terribly good at predicting.