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Resources
Coping
With Inflation Risk
by
Richard Barrington, CFA
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
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)
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.
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.
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