While there’s a wide range of numbers by which to measure inflation—such as the cost of energy, food, housing, and healthcare—they all share one point in common: by nearly any measure, it’s higher than it’s been in quite a while, and interest rates are rising to meet it.
Responses to inflation have already started: the Fed has raised interest rates, businesses are revisiting their growth plans, and consumers are thinking twice about their purchases, especially in markets where inflation is having its greatest impact. But as everyone adjusts their behaviors and expectations in response, investors are eager to know what to do in these uncertain times.
Historic insights about inflation
If we look to the past, we can find ample evidence of just how hard it is to reliably anticipate various markets’ reactions to current events. Consider the following relevant examples:
Global investing and inflation: In their 2021 analysis “US Inflation and Global Asset Returns,” Wei Dai and Mamdouh Medhat of Dimensional Fund Advisors studied how bonds, stocks, industry portfolios, factor premiums, commodities, and REITs performed during periods of high and low U.S. inflation from 1927–2020. They found “most assets had positive average real returns in both low- and high-inflation years.”
Bond investing and interest rates: In “All Eyes on the Fed?” Dimensional Fund Advisors also examined whether Federal target funds rate changes have influenced either global government bond returns, or longer- vs. shorter-duration bond returns. They concluded: “Our analysis of global government bond data from 1984–2021 shows no reliable relation between past changes in the federal funds rate and either future bond excess return over cash or future term premiums.”
Factor investing and economic cycles: One of our timeless investment strategies is to allocate our portfolios across various market “factors,” or sources of expected return, in pursuit of particular long-term outcomes. In an Alpha Architect guest post, “Factor Investing Premiums and the Economic Cycle,” Swedroe also examined whether it had made good historical sense to shift those allocations in response to economic cycles. Bottom line, it had not. Compiling the findings from several academic studies, he concluded, “Although a factor’s return changes throughout the business cycle, the ability to predict economic regimes and alter factor allocations accordingly produces less successful results despite being intuitively pleasing.”
Although what you see on the news may make you want to take action, historically, it makes me sense to avoid the influence of current events and focus on what’s in front of you.
Utilizing your layers of protection
If your investment portfolio is already well-structured, you should already be well-positioned to capture appropriate measures of expected investment premiums over time, while defending against inflation and other risk/reward tradeoffs. At the same time, it’s worth reviewing what you are seeking to achieve as an investor by deploying two broad strategies for protecting against inflation:
Hedging against inflation: To preserve the spending power of upcoming cash flows out of your portfolio (such as in retirement), you can hedge some of your assets against rising inflation.
For example, you can allocate more of your fixed income to assets that tend to move in tandem with inflation, such as Treasury Inflation-Protected Securities (TIPS) versus “regular” Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across various inflationary rates.
Outperforming inflation: At the same time, your longer-term financial goals typically require a portion of your portfolio to outperform inflation over the long haul. For that, you need to stay invested in various markets. As Dimensional’s Dai and Medhat concluded in a recent report, “Overall, outpacing inflation over the long term has been the rule rather than the exception among the assets we study.”
- Stocks: Equities in general have handily outpaced inflation over time.
- Bonds: Investing in bonds that offer the highest yield for the least amount of term, credit, and call risk is also expected to help a portfolio stay ahead of inflation over time. (A timely tip: As in any other market, avoid trying to time the bond market in response to breaking news.)
Most investors require elements of both hedging and outperforming inflation, calling for portfolios that are constructed accordingly. Additional defenses against inflation can include: (1) using relatively realistic inflation estimates in your financial and retirement planning; and (2) delaying taking Social Security when possible, to maximize the power of the COLA (cost of living adjustments) on higher monthly payments.
Mowery & Schoenfeld Wealth continues to deploy the same core principles we use to help people invest across time and through various market conditions. These include:
- Risk appropriate investment strategies that help build, protect, and manage wealth through every life stage
- Minimizing exposure to concentrated investment risks through global diversification
- Reducing the impulse to act on fear, excitement, and similar reactions to unfolding news
- Keeping an eye on tax ramifications and other costs
If anything, adhering to these timeless tenets becomes even more important during increased geopolitical uncertainty and economic stress. It’s important to remember the decisions you make moving forward should always be grounded in your own circumstances.