A version of this article previously appeared on CNBC.com.
The recent upswing in inflation has renewed investors' interest in assets that may help preserve the real (inflation-adjusted) value and purchasing power of their portfolio. The good news is that the typical investor's portfolio likely contains all the inflation-fighting tools that they need – such as stocks and bonds – save one: perspective.
How can investors gain the perspective they need to contend with inflation? In my opinion, it starts with answers to two key questions:
Is your focus on the short-term – say, less than 5 years – or longer-term?
For most investors, the purpose of their investment portfolios is to fund either current or future spending. Because many people expect the prices for goods and services to be more expensive in the future than today, to preserve their purchasing power their assets need to grow at a rate at least equal to the rate of inflation. The most common assets used to provide this inflation-adjusted growth are stocks and bonds and the real returns from these assets have well-outpaced inflation over the long term (Figure 1).
Historically, higher returns and higher risk are well correlated. Whether in inflation-unadjusted (nominal) or in inflation-adjusted (real) terms, common stocks provided higher average annual returns with higher risk (standard deviation) than bonds, and both delivered higher returns and risks than T-bills, a proxy for a 'risk-free' investment. Notably, T-bills have delivered negative real annual returns more often than either stocks or bonds.
Despite their low and often negative real returns, T-bills and other lower risk assets such as money market funds and shorter-term bond funds can serve an essential purpose for investors with short-term focuses. Because inflation's erosion of value is most significant over time, the longer the investment horizon, the more concerned one should be about the portfolio's future purchasing power (Figure 2). Over the shorter-term, the effects of inflation are less pronounced and even at unusually high inflation rates the vast majority of purchasing power remains intact. That makes principal risk a greater threat than inflation to portfolios with short time horizons: The worst annual U.S. inflation rate since 1926 was 18.1%, while the worst 1-day loss for the U.S. stock market was 22.6% in October 1987.
For investors with shorter-term investment horizons, an investment strategy designed to eliminate or substantially reduce chance of sizable losses may be more prudent for these portfolios. For longer-term investment horizons, however, an emphasis on higher real returns may be preferable, particularly where less certain spending needs or growing purchasing power are significant factors.
Are your future spending needs more certain or less?
Clearly, the more one knows about their future spending, the better one care prepare for it. However, trying to figure out how much you will need save for future spending in retirement, for example, is rarely so predictable. Who can say how much food, healthcare, and other essentials will take from their nest-egg?
If everyone's future spending grew at the same rate as inflation, then investing could be as simple as buying Treasury inflation-protected securities (TIPS) which are designed to do just that, plus provide a small real return to help marginally grow your portfolio. Unfortunately, it's not that simple, which is why most investors need to be conservative in their estimated spending by assuming they will need to do more than just keep pace with inflation's growth.
In setting their portfolio strategy, the decision to include higher real returning assets – such as stocks – involves a trade-off: To contend with the uncertainty of the future value of their spending, investors must accept the uncertainty of the future value of their assets. The longer the time horizon and the more uncertain the spending, the more acceptable this trade-off might be.
Perspective pays off.
Inflation is an important factor for investors to consider, as it affects both their portfolio's current value and future spending power. While there are other assets that may add inflation-fighting benefits to investors' portfolios, their historical performance results and often high costs are far from compelling. The good news is that the assets that most investors already use – stocks and bonds – equip them with the potential real returns that they will need, when proper perspective is applied. For investors with short investment horizons or more certain spending needs, an emphasis on preservation principal and the use of high-quality short-term bonds, TIPS, or even money market funds should suffice. For all others, however, a strategy emphasizing potentially higher real returning assets – such as stocks -maybe be the appropriate compromise to contend with uncertain future spending needs.