A common risk to investments that is typically an afterthought is the risk that your money will lose purchasing power in the future. Why is it an afterthought? Its symptoms are mostly imperceptible from day-to-day, so we focus on more pressing things like the potential loss in value caused by a March 2020-style crash. In our hopefully-soon-post-COVID environment, we will be forced to grapple with the effects of the massive efforts taken by both the government and Federal Reserve to keep our economy afloat. Where will we feel the effects? What can be done to protect your investments?
Inflation is tricky. There is no easy way to define it. On the surface, it seems simple – the price of things going up. But which things? How much weight should we assign each item in a basket of goods? We are also not entirely sure what causes it. Many prepared for a hyperinflationary environment in the wake of the Global Financial Crisis that never materialized. Everybody is well aware of the inflation that has existed throughout the past decade(s) in healthcare and education, but perhaps post-COVID inflation will look different. A rush to the suburbs and a shortage of housing supply has seen the price of lumber quadruple in less than a year. We have also seen the price at the pump awake from its slumber and essential agriculture commodities like corn and soybeans have appreciated meaningfully in the past few months.
In a portfolio, fixed income will bear the brunt of inflationary pressures the most. This makes sense. If you are expecting to receive a pre-defined stream of future payments in a world where future dollars are worth less, the price of that instrument will adjust downward to reflect this. An allocation to an inflation-protected bond issued by the government would help to offset this. Another option to protect your portfolio is commodities. They were the hedge of choice at the beginning of the last decade, but they were coming on the heels of explosive growth in the prior decade and needed a chance to breathe. As you can see in the accompanying chart, they have been lying in wait for the last five years and this could be their time to shine.
It should be mentioned that nothing is set in stone and decisions about your investments should be made in the context of your complete financial picture. Focusing on just one risk that may or may not materialize potentially leaves you exposed in other areas. A finely tuned financial planning process combined with investment implementation can only help to set you up for financial success.
Author: David Rath, CFA
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