Managing Inflation Risk
With short-term interest rates below 1%, investors are concerned about the inflationary effects of rising federal spending and debt. Because inflation destroys the value of money, it’s understandable that investors want to address inflation uncertainty in their portfolio.
When building a portfolio, investment managers prepare for unexpected inflation with two basic strategies. First, they work to hedge the immediate effects of inflation by allocating to short-term bonds that have frequently updated yields. Second, they attempt to earn a total return that outpaces inflation over time by investing in equities and Treasury Inflation Protected Securities (TIPS).
When interest rates are increasing, opting for shorter maturities enables a bond manager to frequently roll over bonds at higher interest rates. This helps investors keep up with short-term inflation and enables total return portfolios to reduce price risk.
Inflation protected securities are a good inflation hedge because their principal is adjusted for changes in the consumer price index. For some long-term investors, TIPS can be a good way to diversify. However, in the short-term, holding these positions may increase a portfolio’s volatility.
In a total return strategy, managers attempt to outpace inflation by holding assets that are expected to earn higher real inflation-adjusted returns. In essence, they forfeit short-term inflation protection for a chance to increase real long-term wealth through equity investing. This strategy requires investors to accept more risk and endure periods when stocks do not outpace inflation.
Despite the availability of short-term bonds as an inflation hedge, investors continue to search for other inflation hedging assets. Some propose commodity futures, oil, and gold to offset inflation risk. These assets are viewed as valuable inflation hedges because investors believe their returns are positively correlated with accelerating inflation. In reality, these assets are riskier than stocks and do not always follow inflation. So should you avoid them altogether? Not necessarily, particularly if portfolio diversification is a goal. Adding a little of these asset classes to a standard portfolio can reduce overall risk.
The entire economy is affected by the risk of inflation. It cannot be diversified away. The only way to eliminate inflationary risk is to accept lower returns. Therefore, short-term inflation hedging is only appropriate for retirees, fixed income investors, and others who would experience a decline in living standards during inflationary periods.
Before altering portfolios to address inflation risk, investors should carefully review their financial circumstances and investment goals. It’s important to consider that current asset prices already reflect expected inflation.
There is an often overlooked cost to hedging unexpected inflation. Investments historically regarded as effective short-term inflation hedges traditionally have lower returns than stocks and may actually increase overall portfolio risk. Even with the outlook for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with accelerating inflation. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors may preserve their purchasing power and grow their wealth.