Perhaps the single most impactful development in the financial world over the last several months is the rapid onset of high inflation. After a decade of particularly low inflation that even pushed negative in some countries, the ugly specter of quickly rising prices came roaring back late last year and has only gotten worse. As recently as March 2021, the annualized inflation in the US was at a historically typical 2.6%. But just one year later it skyrocketed all the way to 8.5%. That’s the highest it has been since 1981, and we can all feel its effects. Everything is just way more expensive today.
With consumer prices making news worldwide, it’s easy to feel helpless. Massive price tags on basic staples like food, gas, and rent have a way of humbling even the most efficient money manager and stressing household earners to the limit. And many investors with lots of money saved up no longer feel so confident either as both the stock and bond markets break under the weight of the new economic normal. It’s really tough out there!
While I don’t have a magic wand to make your grocery bill more affordable, I’m happy to help where I can. So let’s tackle the investing side. Not every asset and portfolio responds to inflation in the same way, and by learning more about how they operate we can find an asset allocation suitable to weather the current storm.
Table of Contents
- What causes inflation?
- How individual assets react to inflation
- Ranking the portfolios
- The top-4 inflation fighting portfolios
- Lessons learned
What causes inflation?
Read any modern article about inflation and its causes, and like most things these days it can quickly get lost in the weeds. After all, when things get bad people who have a hand in the situation tend to revert to the blame game. But if you look beyond the petty minutia, inflation generally comes down to three main factors: supply, demand, and debt.
When products become more scarce, customers are willing to pay more to secure them over the competition. Lots of things can drive scarcity. The war in Ukraine has made wheat supplies a lot tighter. Government regulation both domestically and abroad can decrease the flow of oil. And global supply chain issues caused by many different factors have severely limited important resources like microchips used by all types of products from cars to graphics cards. Anything that reduces the supply of a product will drive up its price.
A scarce product still won’t cost much if there’s no market for it. More popular products can demand a higher price than less popular products. And while people talking about inflation sometimes speak of it as some universal constant, varying demand also means that not all products experience the same inflation. After all, when money gets tight people tend to stop buying nonessential items to prioritize the basics like food and energy.
That’s why the inflation in things like groceries and gas is often higher than you see in other categories. And it’s also why any report that conveniently ignores those staples when calculating inflation will naturally understate what you can see with your own eyes and feel with your own monthly bills.
While most people have heard of how supply and demand drive inflation, the third important factor is debt. Armchair economists may also discuss this as “money printing” that sounds like cash is just raining from the sky somewhere, but the easier way to understand it is the government expanding the capacity of the banks to make new loans. When people have convenient access to lots of money via debt, they’re willing and able to pay more for products they want.
The classic examples are residential housing and college education, as the prices of both would immediately plummet if easy loan access was cut off to buyers and students. And when you also account for massive corporations who have direct access to that new money to do things like buy up the housing market, you can see how that might affect prices overall.
Supply, demand, and debt. The delicate balance of the three are what drives the economy overall, and when one or more gets out of whack inflation can go haywire. Just like we’re seeing today.
I can’t stop inflation, but I can do my part to help. To go along with this article I also reduced the price on many store items! Stock up on investing supplies and support a good cause.
How individual assets react to inflation
Regardless of the cause of inflation, at some point it doesn’t really matter to most people. Stressing about things largely out of your control will only cause you grief, while addressing the things you actually can control is a far more productive mindset. So with prices soaring, it’s only natural to seek out asset options that might be able to help.
Unfortunately there’s really not one single silver bullet to solve the problem, but many options have a role to play. Here are some of the most popular.
Owning stocks is a good way to hedge against inflation when the economy is in good shape. As people pay more for the same product, it tends to also buoy the stock price of the company selling it.
Of course, anyone watching the stock market lately will immediately recognize the problem with that prospect. Stock prices are driven by many more factors than simply product prices, including things like operating costs, product demand, interest rates, and a bunch of other factors. As a wise boss once told me, there are 10,000 ways that a good company can still die. Many companies that once seemed invincible are suddenly struggling mightily in ways that far outpace inflation, so it’s important to look beyond simple corporate growth for a solution. Even if stocks do eventually catch up, it can take time.
When faced with the prospect of a down market, the natural reflex for many stock investors is to diversify their stocks internationally. It’s a great idea in a lot of cases but inflation is a unique situation. That’s because while you may be able to invest in the entire world using a single fund today, you can still only live in one place at a time. And the inflation where you live is all that really matters.
In fact, when it comes to some things like safe withdrawal rates, the data suggests that international diversification can sometimes even be counter-productive. You can read much more about that in this article:
But the high-level summary is that when both inflation and exchange rates can vary by double-digits between countries, detaching the engine of your returns from the inflation it needs to account for may have negative consequences for your portfolio that you did not anticipate.
This is where it starts to get a little tricky, as the type of bonds you’re talking about makes a huge difference in how they respond to inflation. It’s important to be specific.
When discussing bonds, it’s also necessary to understand how the interest rates that drive their returns are related to inflation. Inflation generally doesn’t happen in a vacuum, and high inflation often corresponds to rising interest rates. Remember the debt we talked about? When you hear news stories about the Federal Reserve raising rates, think of it as the government putting the brakes on lending in order to counter inflation by reducing access to debt.
So with that framework in mind, let’s cover a few options:
- Long Term Bonds — Long term bonds are particularly harmed by rising rates due to the effects of bond convexity, and that’s easy to see with the recent performance of funds like TLT that are currently down almost 20% this year. So they’re really not a good inflation hedge at all.
- Short Term Bonds — While short term bonds also lose money with rising rates, the capital loss is much less than that experienced by long term bonds due to the same convexity effect. And they actually benefit from rising rates as expiring bonds roll over into new issues with new higher rates. As a result, while it’s definitely not intuitive nor immediate, short term bonds and other cash equivalents like Tbills are actually some of the best inflation hedges money can buy. Don’t believe me? Read this: Understanding Cash Will Make You a Better and Happier Investor.
- TIPS — TIPS are shorthand for Treasury Inflation-Protected Securities, and the purpose is right there in the name. Their coupon payments are adjusted every year for inflation, which makes them extremely popular options for investors looking to hedge against the prospect of rising prices. But while they’re indeed good choices, they also don’t work the way most people think.
To explain, let’s look at a popular US TIPS fund offered by iShares that goes by TIP. In the 12 months between April 2021-2022, inflation went up 8.3%. Over the same timeframe (according to ETFreplay.com), the inflation-adjusted return of TIP was -8.1%. You’re reading that right — it only tracked 0.2% above the inflation rate and was almost no better than stuffing paper cash under the mattress.
So what happened? Did the fund break? Did the government lie about inflation? Actually, neither. TIPS are just more complicated than most people think.
The important thing to remember about TIPS is that while they do adjust for inflation, they’re also bonds that rise and fall with interest rates. TIP has an intermediate average maturity of a little under 8 years, which means it’s also moderately affected by rate changes somewhere between long and short bonds above. So as rates rose over the past year, intermediate TIPS gave back all of the inflation protection that they paid out. It was certainly better than a capital loss with no inflation adjustment, but it also was no purchasing power panacea.
While TIPS can indeed be an important inflation-fighting asset in a portfolio, always remember that the real return is not at all guaranteed to be positive!
- I-bonds — One of the lesser-known bond options that are suddenly getting extremely popular again are I-bonds offered by the US treasury. Like a mixture of very short-term bonds and TIPS, they get the dual benefits of not only adjusting for inflation but also being mostly immune to the return-negating effects of rising interest rates. It’s such a good deal, in fact, that the government limits the amount that you can acquire in a year. But if you want to hedge against inflation, I-bonds are definitely worth your attention.
The single asset with the most storied history when it comes to inflation is the shiny metal that has been valued for centuries. While I would argue that the data does not back up the assertion that the gold price is strongly correlated to inflation, it does suggest that a related factor — real interest rates — does have a significant effect on the price. Rather than diving into that here, allow me to point you to an article that explores it in depth:
Click here if you want to skip directly to the inflation discussion
The short story is that while the current balance of inflation and interest rates is a bit of a moving target, the conditions do seem ripe for gold to do its thing. For reference, in comparison to TIPS that lost 8.1% real in my previous example, gold only lost about 2.9% over the same timeframe. There are of course a lot of noise and other factors involved, but it does go to show that gold has survived as a durable store of value for so long for a reason. And I see no evidence that it’s changing any time soon.
Are you stressed about how inflation is affecting the price of housing? REITs naturally account for that price increase by directly benefitting from rising rents. It may not be immediate, as it takes a little time for leases to roll over into new higher numbers. And it may also may not be perfect, as REITs are still technically stocks that are subject to other competitive forces as well. But in general, real estate can serve as an effective hedge against inflation and REITs are the easiest way to take part on an individual basis without a lot of effort and capital.
Ranking the portfolios
While looking at individual assets is certainly educational, any long term reader of Portfolio Charts knows that studying them in isolation doesn’t really tell the whole story. So let’s shift gears and answer the question truly on everyone’s mind.
What portfolios have fared the best in times of high inflation?
I know it’s tempting to simply rank the portfolios over the past 12 months or so since inflation took off, but it starts to feel a little shortsighted when you think about scale. Things as huge as global asset markets aren’t particularly nimble, and sometimes it requires a bit of patience to see how they react to inflation as it builds up over time. Like a massive battleship turning the rudder, they take time to switch direction.
To attack this one, I think it’s best to go back to the stat that is making so much news — that the current inflation rate is the highest anyone has seen since 1981. You’re saying it was even higher back then? Great! In fact, not only was it higher but it also lasted for several years in a row. It was so bad that it even earned the nickname The Great Inflation that economists have studied for decades. So let’s think beyond recent history and talk about the worst case we have on record.
If you think today’s 8.5% inflation feels bad, picture yourself living in the US during the late 1970s when inflation increased by 11.3%, 13.5%, and 10.3% for three miserable years between 1979 and 1981. It eventually cooled starting in 1982 before starting its slow descent to the low sub-3% level people often take for granted. But for those long and painful three years, inflation was pretty out of control.
So to truly understand how different portfolios handled high levels of inflation, I went back and calculated the total cumulative real return of every portfolio (plus a few extra useful datapoints) for the particularly tough investing period from 1979 through 1981. Take a minute to study it before moving on.
There’s a lot to unpack here, so let’s start with the extremes.
- In the worst case on the right you can see the experience of a completely uninvested person who held onto their paper cash and watched it erode in value by 31% in just three years. That’s absolutely brutal. Selling everything and just sitting on your hands was clearly the worst possible choice.
- In the best case on the left is a Total Stock Market fund. Unsurprisingly, the only portfolio that completely ignored bonds fared the best as inflation took off and interest rates also launched into a ridiculous double digits. Of course there are also tradeoffs with that portfolio choice, such as the massive 51% loss over two years just before this timeframe that put petty inflation losses to shame. But for the purposes of staying afloat during this time of high inflation, stocks got the job done.
- Next, take a look at the column for cash. Did you expect that result? I added that just to reiterate my earlier point about short term bonds, as the recent historically-low interest rates for cash have falsely convinced an entire generation of investors that cash earns nothing and always loses to inflation. Properly invested cash is way more dynamic than people think.
Now before we jump to conclusions about specific portfolios, I think it would be best to tap the breaks and consider the possibility that this one timeframe in the United States may have included unique situations that bias the portfolio results.
To test that, I ran the same analysis in a very different country and currency that was suffering through its own major inflation problems at the time — the United Kingdom. Note that not only does this convert the portfolio returns to local British currency and inflation, but it also interprets each portfolio through a local lens where “domestic” means Europe and “international” means the US. I like to do this to test the fundamental theory of each portfolio strategy beyond typical US market bias.
As you can see, the inflation was even worse and the order was quite a bit different. I’m glad I checked! But there are definitely some notable patterns.
- Interestingly, the Total Stock Market and Cash portfolios both landed at about the same spots that they did before. So clearly the equity and cash results were not mere artifacts of the unique US market. Their inflation-fighting qualities also worked in a completely different economy and currency.
- If you’re wondering what happened to the portfolios like the Golden Butterfly, Pinwheel, No-Brainer, and Ideal Index portfolios that scored highly in the US but poorly in the UK, it’s interesting to note that the difference in each of their positions is directly proportional to their small and value tilts. I looked it up, and while small and value companies did very well in the US during this timeframe (surpassing large caps by a good margin), they had a much tougher time in Europe and failed to keep track with inflation. So anything with SCB or SCV looked a lot better in the US than it did in the UK, and this is a good example of why studying data in other countries is important.
One could continue to look at multitudes of countries, and if you happen to live outside of the US and UK I encourage you to explore the many charts on the site that account for a dozen different options. But as a baseline sample goes, these two charts are a pretty good place to start for inflation protection ideas.
If you’d like to run a similar analysis using countries or assets not included in the normal charts, check out the new standalone tools. They can calculate the same numbers from any data that you provide.
The top-4 inflation fighting portfolios
Put those two sets of rankings together, and there were four portfolio options that stayed above water during this particularly high inflation period in two very different economies. So let’s unpack each one and see what they have in common.
- 100% Total Stock Mkt
- 25% Total Stock Mkt
- 25% LT Bonds
- 25% Cash
- 25% Gold
- 48% Total Stock Mkt
- 24% Int’l Stocks
- 20% IT Bonds
- 8% REITs
- 30% Total Stock Mkt
- 15% Int’l Stocks
- 5% Emerging Mkt
- 30% IT Bonds
- 20% REITs
Allow me to point out a few observations:
- Because of that underperformance of small and value tilts that we talked about in the UK, probably the most notable feature shared by all four portfolios is a complete lack of factor stocks. That’s a really interesting outcome that I didn’t expect to see because of the number of portfolios on the site that include those tilts, and I think it offers an important lesson for investors inclined to explore increasingly complicated asset options to solve problems. When it comes to big issues like inflation, relatively simple portfolios can often be the most impactful. Think broad, not deep.
- While the Total Stock Market portfolio was a pretty good option by itself, I find it interesting that the percentage of stocks varies quite a bit across all four portfolios. In fact, there are good options with 25% 50%, 75%, and 100% stocks. Loading up on volatile stocks is not at all required to fight inflation, and there are other good options no matter where you fall on the stock ownership spectrum.
- The one diversified portfolio that performed the best in both countries was the Permanent Portfolio, which returned just under 10% real in both situations. While some people may be surprised that a portfolio with 25% long term bonds survived inflation so well even with skyrocketing interest rates, if you look at the other assets it makes a lot more sense. With stocks, cash, and gold, the Permanent Portfolio includes not one but three assets that all play a role in combatting inflation. And clearly they were more than enough to pick up the slack for long term bonds even without changing a thing in the portfolio.
- Another interesting commonality between the three diversified portfolio options is the structure, as they each choose to allocate money across roughly four different assets. They do utilize a few different options, as some prefer REITs over gold or international stocks over a second type of bonds. But with money broadly diversified over multiple high-level categories of stocks, bonds, and real assets, they all share a common feature of not putting their eggs into any one basket.
- Finally, I think it’s important to point out that all of these portfolios are currently underwater right now in 2022. The lesson here is NOT that there is some magic combination of assets that will prevent you from ever losing money to inflation. It sometimes takes markets a little time to adjust to new economic realities, and the portfolios will follow if given the time and space without you panicking and changing everything on the fly. So staying the course with a dependable portfolio is not so much about covering your eyes and ignoring current performance, but about having the perspective and confidence to know that the battleship is turning at its own pace. Stay the course, and you’ll be fine.
This is a complicated topic and we’ve obviously covered a lot of ground, so here’s a quick recap of the important takeaways:
- Inflation is caused by changes in supply, demand, and debt.
- Every asset reacts to inflation differently. Some like long term bonds severely struggle as rates rise. Others like domestic stocks, gold, and cash can respond quite positively.
- Portfolios that diversify across multiple inflation-adjusting assets like stocks, shorter-term bonds, and real assets tended to do well during times of high inflation not only in the US but also elsewhere.
I would also argue that the most important lesson can be found in what did not matter. The Permanent Portfolio did just fine even with long term bonds that get killed by rising rates. The Core Four and Swensen portfolios succeeded even with less-than-ideal international stocks that perhaps don’t always track local inflation as well as you’d like. And the overall percentage of stocks really didn’t seem to matter at all, as there were good inflation-righting options at any stock level.
In other words, effective investing is not necessarily about avoiding bad situations for every asset or about optimizing for every new market trend. Another way to approach it is to responsibly diversify risks so that you’ll be fine no matter what happens. It’s all about balance.
By investing in one or more inflation-fighting assets like stocks, cash, gold, and real estate, each of these four portfolios set themselves up for success against inflation. And by resisting the urge to jettison other assets less suited for that one task, many of them also prepared themselves for other very different future economic conditions or for new inflation scenarios that will be similarly studied years from now.
So as you think about your own portfolio as prices continue to rise, consider not only what you might want to change but also what you might need to keep. The happiest investors generally aren’t the ones constantly adjusting from one crisis to another, and the foundation you choose can make all the difference in the world to your long term investing satisfaction.
Yes, inflation sucks right now. But with the right portfolio and the patience to let it operate, your investments can handle it. Rather than reacting to market stresses, take the time to evaluate your options and proactively plan. And when high inflation eventually passes, you’ll be able to look back and be proud of your ability to persevere.
Did this give you some good ideas for dealing with inflation?