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Recent swings in inflation have renewed investor interest in assets that can help maintain the real (inflation-adjusted) value and purchasing power of their portfolios.
The good news is that the typical investor’s portfolio will include all the inflation-fighting tools they need, such as stocks and bonds. However, the best way to fight inflation for an investor is really perspective. It means taking a step back and looking at the big picture.
How can investors get the perspective they need to fight inflation? In my opinion, that starts by answering two key questions: Are you focused on the short term? Or are you focusing on the long term?
In short, the key for investors is to set financial goals and build a personal and diverse portfolio to complement them.
For most investors, the purpose of their investment portfolio is to fund current or future expenses. Since many people expect the prices of goods and services to be higher in the future, they must find ways to maintain their purchasing power and keep their wealth at least equal to the rate of d ‘inflation.
The most common assets used to provide this inflation-adjusted growth are stocks and bonds, and the real returns on these assets have far exceeded long-term inflation.
Historically, high returns and high risk correlate well.
Whether looking at inflation-adjusted (nominal) or inflation-adjusted (real) terms, common stocks have provided higher average annual returns with higher risk than bonds. Both generated higher returns and higher risk than treasury bills, a proxy for “risk-free” investments. In particular, treasury bills have more often given negative real annual returns than stocks or bonds.
Despite their low and often negative real returns, treasury bills and other low-risk assets, such as money market funds and short-term bonds, can serve a critical purpose for short-term investors. Because the erosion of the value of inflation is greatest over time, the longer the investment horizon, the more concern there is about the future purchasing power of the portfolio.
In the short run, the effects of inflation are less pronounced and the vast majority of purchasing power remains intact, even at unusually high inflation rates. This makes head risk a greater threat than inflation for short-horizon portfolios: the worst annual inflation rate in the United States since 1926 was 18.1%, compared to the worst one-day for the market. US stock market in October 1987. The loss was 22.6%.
For investors with shorter investment horizons, investment strategies designed to eliminate or significantly reduce the potential for massive losses may be more cautious for these portfolios. For longer-term investment horizons, however, it may be better to focus on higher real returns, especially when lower spending needs or increased purchasing power are important factors.
Do your future expenses need more fixed or less?
Clearly, the more a person knows about their future expenses, the better they can prepare for them. However, trying to figure out how much you’ll need to save for future expenses in retirement, for example, is rarely predictable. Who can say how much food, health care and other essentials will come from this nest egg?
If everyone’s future spending keeps pace with inflation, investing can be as simple as buying inflation-protected Treasury securities, which are designed to do just that. They can also provide a small real return to help you grow your portfolio slightly.
Unfortunately, it’s not that simple, which is why most investors need to be careful with their projected spending, assuming they’ll have to do more than just keep pace with inflation.
When establishing a portfolio strategy, there is a trade-off to the decision to include high real return assets, such as stocks. To cope with the uncertainty of the future value of their expenses, investors must accept the uncertainty of the future value of their assets. The longer the delay and the more uncertain the expense, the more acceptable this compromise can be.
Inflation is an important factor for investors because it affects both the current value of their portfolios and their future purchasing power.
While there are other assets that can add inflation-fighting benefits to investors’ portfolios, the results and often high costs of their historical performance are far from convincing.
The good news is that the assets most investors use – stocks and bonds – give them the potentially real returns they’ll need, when the right perspective is applied.
For investors with a shorter investment horizon or more fixed spending needs, the emphasis on preservation of capital and the use of high-quality, short-term bonds, treasury securities protected against investment. inflation or even money market funds should be sufficient.
However, for everyone else, a strategy emphasizing potentially high real-return assets – such as stocks – may be an appropriate compromise for those struggling with uncertain future spending needs.