Inflation is often thought of as a rise in the prices of goods and services. While this is true, inflation is actually an increase in the money supply. When there is more money chasing after goods and services, prices will naturally rise. This puts investors in a difficult position because they must account for the effects of inflation when making investment decisions.
Inflationary periods can be difficult to navigate. But are there any ways to protect your portfolio?
Reference [1] examined the assets’ returns during times of inflation. It pointed out,
Deflationary periods, where inflation is below 0%, coincide with relatively low nominal returns for equities of 2.4% per annum, well below the 8.4% unconditional average return. Bonds and cash show a 5.2% and 2.8% per annum nominal return during deflationary periods, which is slightly above the unconditional average of 4.5% and 3.4%. Consequently, a multi-asset 60/40 investor achieved a 3.5% nominal return during deflationary periods. However, an investor that does not suffer from money illusion realizes that even though the nominal return is low, the real return is decent because of the deflation. Adjusted for purchasing power, the multi-asset investor earns 6.7% per annum during deflationary periods.
Inflationary periods, where inflation is above 4%, show a positive nominal returns for equities (6.9%) and bonds (3.9%). At face value, it may seem that the multi-asset investor does quite well with a 5.7% nominal return. However, the real return is substantially negative at -2.9% per annum, leading to a severe reduction in purchasing power.
In short, during a period of very high inflation, the real return is negative. In other words, investments in stocks and bonds will not be able to keep up with inflation.
So what’s the solution? Should we concentrate our investments in commodities and precious metals because they are a direct hedge against inflation? Let us know what you think in the comments below.
References
[1] Baltussen, Guido and Swinkels, Laurens and van Vliet, Pim, Investing in Deflation, Inflation, and Stagflation Regimes (2022). SSRN: https://ssrn.com/abstract=4153468
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