Coping With Inflation Risk

By Richard Barrington AAA

Inflation, although not as dramatic as a market crash, can be even more devastating in the long run, steadily eroding the value of a portfolio year after year. Moreover, it is prone to flare-ups, which can make its effects especially acute. These effects include:

  • Reduction of purchasing power
  • Disruptions to stock and bond markets, which may cause volatility
  • Devaluation of income on interest-bearing securities
  • Squeezing of the profit margins of certain types of stocks

From an investment standpoint, this means inflation is a risk to be managed and balanced against more obvious forms of risk, such as volatility and loss of principal. (To read more about inflation basics, see All About Inflation.)

Historical Examples of Inflation
Inflation is the increase in the price of goods, services, commodities and/or wages. A look at past inflation numbers illustrates what inflation is capable of doing.

According to the widely recognized Ibbotson compilation of data, inflation in the United States averaged 3% annually from the beginning of 1926 through the end of 2007. As is often the case though, long-term averages do not reflect the extremes along the way that can also be instructive in understanding inflation.

While inflation averaged 3% during those 82 years, there were 10 years in which inflation was negative, meaning that prices, in aggregate, actually declined. At the other end of the spectrum, there were four years in which inflation increased at a double-digit rate.

These extremes, which tend to come in bunches, often have a cumulative effect. For example, during the 10 years ending in 1935, inflation decreased at a rate of 2.6% per year. As a result, an item that 10 years prior sold for $100 cost $77.10 in 1935 - a substantial decline in price. On the other hand, during the 10 years ending in 1982, inflation averaged 8.7% annually. Consequently, an item that 10 years prior cost $100, more than doubled in price to $229.65 by 1982.

Even with these extremes, the American economy has never experienced the true extent of inflation risk. Hyperinflation, which occurred in Germany during the 1920s and still crops up from time to time in isolated developing economies, can rapidly devalue a currency and cause economic chaos.

Portfolio Impacts
For investors, the portfolio impacts of inflation can be discussed in terms of the long-term, overall impact, and the short-term disruptions on specific asset classes.

In the long term, inflation erodes a portfolio's purchasing power. At an average inflation rate of 3% per year, the value of a portfolio is cut in half every 23 years or so.

In this respect, the impact of inflation is every bit as severe as that of a market crash - and even more devastating in the long run. Historically, U.S. stock market crashes are always followed by a recovery, even if it is a long and painstaking one. In contrast, because periods of deflation (negative inflation) are rare, the effects of inflation tend to be permanent.

Thus, investors cannot ignore inflation risk, which unlike other forms of risk, cannot be avoided simply by investing conservatively (or not at all). Even cash held in the safest vault in the world is subject to the steady erosion of purchasing power as a result of inflation.

What You Can Do to Protect Your Portfolio
Therefore, the first step toward fighting inflation is to be constructively invested. The challenge of this is that in the short term, periods of inflation are disruptive to all sorts of financial assets. During the highest 10-year period for U.S. inflation, from January 1, 1973, through December 31, 1982, the following were the cumulative real returns (overall returns adjusted for inflation) for stocks, bonds and T-bills:

January 1, 1973, through December 31, 1982
Asset Class Cumulative Real Return
Stocks -16.85%
Long-Term U.S. Bonds -23.73%
T-Bills -1.93%

Looking at longer-term data, however, adds a very different perspective:

January 1, 1926, through December 31, 2007
Asset Class Cumulative Real Return
Stocks +882.37%
Long-Term U.S. Bonds +572.35%
T-Bills +72.28%

Some critical takeaways from this data include:

  • When inflation was at its most extreme, none of the major investment asset classes were able to keep up with the rate of inflation
  • The effects of extreme inflation were felt most severely by bonds
  • While T-bills came closest to keeping up with inflation at its most extreme, they offered the weakest long-term return (both before and after inflation)

(Keep reading about real returns in What You Should Know About Inflation and Curbing The Effects Of Inflation.)

Commodities and Inflation
Commodities (oil, grains, metals, etc.) are often touted as a portfolio hedge against inflation. There is some logic to this, as commodity prices tend to rise during periods of inflation, and in turn, rising commodity prices can be a key root cause of inflation. (To read more about commodities, see Commodities That Move The Markets and Commodities: The Portfolio Hedge.)

Unfortunately though, there are some risks associated with investing in commodities:

  • They have no income or earnings stream; as a result, they have no inherent value beyond their market prices, which are totally dependent on the perceptions of other investors.
  • They are prone to periods of speculation, which causes volatility. This is especially true during inflationary periods, meaning commodities might be at their most risky just when they seem most appealing.
  • They are not a perfect inflation hedge.
    • First of all, there are many types of commodities, not all of which will rise equally during inflationary periods. Inflation can be driven by particular commodities (ex. oil), which may actually dampen the price of other commodities.
    • Second, not all inflation affects commodities. For example, wage inflation can impact the price of finished goods and services without increasing the price of commodities.

Commodities are good hedges for people and businesses subject to very specific risks based on particular commodities, or for sophisticated investors with a detailed perspective on inflation. However, commodities are not good mainstream portfolio investments for the average investor.

Portfolio Construction
Given its profound impact, inflation has to be addressed by any long-term investment portfolio. While there are no perfect hedges against inflation, there are some rational investment responses to inflation concerns:

  • A long-term perspective is critical. In the short-run, no asset class is a perfect inflation hedge, but because the effects of inflation are most devastating on a cumulative basis, long-term returns matter most.
  • Stocks play a crucial role. While stocks may be more subject than other asset classes to loss of principal, they can help a portfolio combat the effects of inflation. This is not simply because they offer the highest returns over time. Fundamentally, stocks represent businesses that are actively adjusting to prevailing conditions, so the earnings stream of a well-diversified portfolio can adapt over time to the inflationary environment.
  • Bonds are most sensitive to high inflation. In some respects, a U.S. government bond may seem like an iron-clad investment, but while its principal and interest are guaranteed, the future purchasing power of that principal and interest can be significantly reduced by inflation.

The above are general observations, but as always, specific market conditions can change the equation. For example, when stocks are highly overvalued, their future returns (and thus their inflation-fighting power) are likely to be diminished. Conversely, because bonds tend to fall in price in response to signs of inflation, their yields may rise to the point at which they represent an attractive premium over inflation. Therefore, investors should target long-term portfolio weightings according to the long-term trends described above, but should also be alert to market extremes which can skew those trends.

To read more about constructing your portfolio, see Portfolios Rise From Oblivion To Omnipresence and A Guide To Portfolio Construction.

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