OUR PROCESS – in an inflationary environment
Admittedly, I genuinely enjoy taking current events and the headlines from today’s news and applying it to our Goals-Based Wealth Management process. Well, the topic de jour these days is inflation. So, in this blog post we will address how our planning process and portfolio management strategies are practically applied in the event we see inflation spike or even persist.
For the better part of four decades, inflation has been held at bay. That means that there is an entire generation of investors and even “experts” who have not witnessed inflation first-hand – ever! I find that quite fascinating. In a “shout out” to our previous blog post on data, knowledge, and wisdom, this observation is merely data. It is not necessarily relevant to how we take care of our clients, but it is an interesting tidbit that makes me feel old.
As is the case with nearly everything in life, the issue of inflation is not as simple as an “if-then” scenario. There are literally limitless iterations and variables to consider; What is/are the cause(es) making prices increase? How long will this last? How high will it go? How sharply/quickly will prices peak? What will the Fed do and when will they do it? All these factors and more influence the ultimate outcome and will determine if your current and future course of action either prevails or fails.
Suffice it to say, there are a myriad of factors involved here that we have no control over. One fundamental tenet of Goals-Based Wealth Management is to control what can be controlled and measure the uncertainty of everything that cannot be controlled. So, in keeping with this principle, let’s look at a few of the popular inflation-hedges used by investors and/or promoted by financial marketeers to see how they have fared in the past when inflation goes wild.
As in the past, we are hearing a lot about protecting your portfolio from inflation by adding Commodities such as Gold to your allocation. Along with Gold, there is always a lot of talk about Real Estate and Equities – both foreign and domestic. During my 57 years on this planet, there has been three major surges where inflation topped between 5% to 8%. The first inflationary spike occurred 12/31/1972 – 12/31/1975. The second spike occurred 3/1/1978 – 2/28/1982. The last time we saw inflation rear its ugly head was all the way back from 12/31/1986 – 12/31/1990.
Based on historical data, none of these assets produced positive real returns in all three inflationary periods. T-Bills, gold, and both foreign and domestic stocks produced positive real returns in two out of three periods. What many folks may find interesting is that 7-10 year Treasuries produced positive nominal returns in all three periods. Wait. What? That’s correct. Before inflation, 7-10 year Treasuries produced positive returns in all three inflationary periods. After inflation of course this was not the case- but then again- it wasn’t the case for any of the other assets listed above either. To be sure, the cost of popular inflation hedges such as commodities and real estate are a CERTAINTY. So, one should ask, if the historical results of 7-10year Treasuries was similar to popular inflation hedges in the three biggest inflationary periods of our past, does the added cost of those popular hedges justify owning them? That’s an important question.
Couple the data during periods of inflation- when these hedges are supposed to shine- with the historical performance for all sorts of other economic periods and the “cost” of these popular inflation hedges goes up. For example, according to Jeremy Siegel’s classic book “Stocks for the Long Haul”, he states that the 200-year real return of gold has been around zero. I have nothing against gold. In fact we like gold- even to the point that we own many publicly traded gold stocks. The same can be true about real estate or any other popular inflation hedge. (By owning the entire stock market, we have a position in “everything”- including popular inflation hedges). The point is that as it relates to any of the popular inflation hedges - if it does an OK job against inflation, a poor job every other time, and costs more all the time, is it a help or a hindrance in the task of protecting wealth?
Another factor to consider is that in a laboratory you often see one asset compared against another, but in the real world, most prudent investors diversify among numerous asset classes. An argument can be made that simply by diversifying properly, a portfolio can be better protected against inflation than being overweighted towards a single so-called anti-inflation strategy.
And one more thing. You should only make changes to your portfolio based on your own personal experience and needs. So for example, over 1/3 of the total price increases occurring at the time of this writing are attributed to used car prices. So, unless you are in the market for a used car every week, are you personally/actually seeing inflation at the levels being reported? We all buy food and food prices are going up, so I’m not saying that we are not experiencing some inflation more than before. What I’m saying is that if your actual and personal inflation is much less than what the media is reporting, does it make sense to make costly and/or questionable changes to your portfolio?
SUMMARY:
Another tenet of Goals-based Wealth Management is that you do not take unnecessary risk. For the better part of the last four decades, inflation has not been a glaring problem. As such, stock volatility has held the top spot for what most consider being the “big risk” in an investment portfolio. With inflation heating up however, market volatility may not be the biggest concern. In the face of historical data supporting diversification over any single inflation hedge, Goals-based Wealth Managers may need to consider increasing equity allocation for those portfolios overweighted in fixed income. In other words, the “lowest risk” portfolio may actually have more stocks in it than conservative models of today.
One distinguishing feature of OUR PROCESS (i.e. Goals-based Wealth Management) from others is that investment portfolio decisions are not driven by the environment, but rather by changes in the funding confidences of a client’s high-valued goals. As the confidence of having more than enough money to fund a client’s goals rises or falls, the portfolio may be altered to either increase or decrease the risk profile depending on the need.
During times of inflation, not everyone will be affected the same. Rather than gaze into a crystal ball or apply one possible outcome to everyone, our process is to stress-test each client’s financial plan by running one thousand possible iterations of what might happen 1yr, 3yrs, or even 5yrs into the future. We also like to look at the funding confidence at the bottom/worst 5% (i.e. 95th percentile) which many would agree represents a reasonable “worst case” scenario.
By utilizing all the tools, strategies, and processes briefly touched in this post, our clients are well positioned to combat inflation and continue to live their best lives.
This is the future of Advice. This is planning done right!