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How should I invest if inflation continues to be high?

Category: Investment

We have previously covered the effect that inflation might have on your financial plan. However, you might also worry about its effect on your portfolio.

Most of us invest to fund future spending. If the stuff you intend to spend that money on gets more expensive and you still want to buy it, you must earn higher investment returns or save more.

High unexpected inflation can negatively impact equities (stocks & shares) and more so on bonds (fixed interest). Overall, equity returns have outpaced inflation. However, they have not done as well in periods of high inflation. This is why we never say that equities are a hedge against inflation. They have delivered higher returns than inflation but that is down to the level of risk being taken.

The price of any investment is highly dependent on what it could be worth in the future. Any prices make an allowance for how uncertain that future value is and inflation. If inflation is higher, then the future value of an investment is lower now. Market prices reflect expected inflation very well. It is when high inflation is a surprise that causes problems in pricing.[1] [2] [3] [4]

If stocks and bonds are not an inflation hedge what else is there?

If an asset tended to go up in value when inflation is high, it would be a good idea to add it to your portfolio. However, such an asset is hard to find.

A recent paper looked at the relationship between US inflation and the performance of various types of investments assets. One of the things they found was that average real returns are lower in years with higher inflation for most of the assets they looked at. The assets they found that did have positive correlations with expected and unexpected inflation were energy stocks and commodities. The only issue was that they found the violent price swings in those assets made them poor inflation hedges.[5] Even those that have advocated for the inclusion of commodities in a portfolio acknowledge their wavering ability to protect against inflation.[6]

So, what should we do?

One of the conclusions that has been taken from this paper [7], and one that we agree with is that this shows the value of diversification. Different investment strategies have been shown to perform well in periods of high inflation at different times. However, none are what you could call hedges. They are all too risky on their own to be depended on. However, having a mix of investments and investment styles should give you the best chance of beating inflation.

Talk to us about how well your plans might cope with higher inflation and what actions you can take to build in the necessary protection. Feel free to book a free no-obligation chat here.

 

 

 

 

 

[1] Eugene F. Fama, G.William Schwert, Asset returns and inflation, Journal of Financial Economics, Volume 5, Issue 2, 1977, Pages 115-146, ISSN 0304-405X, https://doi.org/10.1016/0304-405X(77)90014-9.

[2] Fama, Eugene F. “Stock Returns, Real Activity, Inflation, and Money.” The American Economic Review, vol. 71, no. 4, American Economic Association, 1981, pp. 545–65, http://www.jstor.org/stable/1806180.

[3] Boudoukh, Jacob, and Matthew Richardson. “Stock Returns and Inflation: A Long-Horizon Perspective.” The American Economic Review, vol. 83, no. 5, American Economic Association, 1993, pp. 1346–55, http://www.jstor.org/stable/2117566.

[4] Dimson, Elroy and Marsh, Paul and Staunton, Mike, Long-Run Global Capital Market Returns and Risk Premia (February 2002). Available at SSRN: https://ssrn.com/abstract=299335 or http://dx.doi.org/10.2139/ssrn.299335

[5] Dai, Wei and Medhat, Mamdouh, US Inflation and Global Asset Returns (July 13, 2021). Available at SSRN: https://ssrn.com/abstract=3882899 or http://dx.doi.org/10.2139/ssrn.3882899

[6] Adam Zaremba, Jan J. Szczygielski, Zaghum Umar and Mateusz Mikutowski, Inflation Hedging in the Long Run: Practical Perspectives from Seven Centuries of Commodity Prices

The Journal of Alternative Investments Summer 2021, jai.2021.1.136; DOI: https://doi.org/10.3905/jai.2021.1.136

[7] Ration reminder episode 178 https://rationalreminder.ca/podcast/178

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