Can you protect your investments from inflation?
[Ed. Note: This is a two-part post on inflation and your financial plan. Each will be slightly longer than usual because inflation is a complex topic. My blogs attempt to make the complex accessible, but not at the expense of accuracy. Please send me feedback and questions.]
In part-one, I wrote about who is exposed to inflation risk and identified low-income workers and retirees as the most endangered.
To minimize exposure to inflation risk, retirees can use both planning techniques or investment strategies. One planning technique we don’t like is to simply spend less, although sometimes that’s the best choice. Technically, one could die younger. We really do not like that. But the math undeniably works.
Here are some planning techniques I like:
Hold stocks and think long term. Retirement is typically modeled on 30 years, a long time in investing. As I discussed last week, stocks have a good chance of outrunning inflation over longer time frames.
Use TIPS for short term expenses: Retirees are withdrawing income from their portfolio and have real term needs – the next few years of expenses! To deal with the short-term needs, keeping a year or two of expenses in Treasury Inflation Protected Securities (TIPS) often makes sense. If you have enough saved, use a dedication strategy like a bond ladder or duration matching.
Take Social Security later: Social Security is not perfectly adjusted for inflation, but it’s still good. Starting withdrawals later (age 70) often improves financial plans, especially in higher inflation scenarios.
Have a home and mortgage: As we talked about last week, a fixed monthly housing price really helps when rents go up from inflation. It’s even better if you have a mortgage at a low rate. If inflation is higher than your interest rate, you are being paid by the bank to hold your home in real terms.
Often, we hear that there are investments that do well in inflation. Gold, commodities, bitcoin, art, real estate, bonds, stocks are all touted regularly in the financial media as inflation hedges.
A hedge is like insurance. It offsets some or all the risk. The most common hedges on Wall St. are derivatives: options, swaps, futures, and forward contracts but those are complex, expensive, and often opaque instruments. Wall St. loves to sell these to retail investors and they rarely deliver on their promise.
In the retail universe, hedging means buying mutual funds or ETFs in your portfolio. For example, an ideal inflation hedge might be a Gold ETF. (Gold, you have probably heard, his fallen out of favor recently as an inflation hedge. This is not a recommendation to buy gold in any form.)
Let’s say you buy the gold ETF for 10% of your total portfolio. If it works the way it’s supposed to when inflation hits, gold goes up 200%! It’s offsets all or some of your other investments that don’t do so well. And even more ideally, the rest of the time that Gold ETF would give you a solid return like stocks or something close.
Let’s look at the characteristics of a great hedge:.
Great hedges are reliable. They show up when you need them and have steady returns. It’s not that helpful if your insurance claim gets paid randomly 10 years later, or never
Great hedges move strongly in your favor when the risk occurs. They have a high ‘hedge ratio” or delta, which means each dollar you invest in the hedge protects more assets.
Great hedges are affordable all the time. Insurance gets super expensive once the crisis starts. You must hold it all the time, and it has to be generally affordable and purchasable in your portfolio.
Great hedges are good investments themselves. It’s not good if the hedge comes at a cost of long-term investment returns.
It won’t surprise you that nothing fulfills all four conditions well. That miracle investment would be cheap, perform reliably better during inflation, and have a good, expected return itself.
Fortunately, there is some recent academic research we can look at to help sort this out. A paper released in 2021 by Campbell Harvey, a highly regarded Financial Economics scholar, sheds some light. It’s called Best Strategies for Inflationary Times and the authors did statistical analysis on the investments reputed as a good inflation hedges.
Spoiler: they didn’t find anything the average retail investor needs and there was no silver bullet.
But if inflation is a real concern to you in the short-medium term, you might want to consider these. (Long term, stocks are best, as we’ve discussed.) I’ve compiled their findings into a table so you can look at the relative strengths and weaknesses of each.
Nothing is an easy pick. To make things worse, there are different causes of inflation. Some things do better than others depending on the cause. So, to really immunize yourself, you need multiple options.
And here’s the kicker. The time to buy inflation insurance in your portfolio is before anyone is worried about inflation. Once worry sets in, prices will skyrocket and sometimes ‘overshoot’. That doesn’t mean taking steps now is useless, there could be more unexpected inflation in our future, but it does mean that at least in the short term the options are pricey.
For most of us with longer time horizons, relying on equities (stocks) in a balanced portfolio is the right choice. If you are especially exposed to short or medium-term inflation risk, using some of these investments might make sense but not for most. Inflation remains one of the most economically baffling issues, and there isn’t a simple answer.
