In our last piece, we covered the recent uptick in inflation, and what to make of it in a historical context. For investors, it’s important to take a step back and look at the big picture before acting on breaking news. What if inflation does get out of hand, and what’s the best strategy going forward if that were to occur?
The Federal Reserve has been suggesting rising rates should wane. We hope they’re right. But we also know the future remains uncharted. Nearly any outcome is possible, and none is inevitable. This means diversified investing remains our preferred strategy for being prepared for whatever the future holds.
Explaining Inflation Doesn’t Predict It
If higher inflation does materialize, will it arrive sooner or later? Will it be moderate or severe? Brief or prolonged? Forecasts vary widely, because we often forget the academic evidence that reminds us that even excellent explanations rarely become effective predictions.
For example, scientists can readily explain why earthquakes occur, but our ability to forecast times, locations, and severities remains shaky at best. The same can be said for inflation. We can explain its intricacies, but accurate predictions remain as elusive as ever. There are simply too many variables: COVID-19, climate change, political action, the Federal Reserve, other central banks, consumer banks/lenders, consumers/borrowers, employers/producers, employees, investors (“the market”), sectors (such as real estate, commodities, and gold), the U.S. dollar, global currency, cryptocurrency, financial economists, the media, the world, time … and YOU.
Each of these could throw off any predictions about the time, degree, and extent of future inflation. Besides, as an investor, you really only have control over the last two: You, and your time in the market. What will you do with your time?
Because We Don’t Know, We Diversify
It stands to reason: Some investments seem to shine when inflation is on the rise. Others deliver their best results at other times. Because we never know exactly when inflation might rise or fall, we believe an investor’s best course is to diversify into and across various investments that tend to respond differently under different economic conditions.
For example, until earlier this year, value stocks had been underperforming growth stocks for quite a while. You may have been tempted to give up on them during their decade-plus lull (during which inflation remained relatively low). And yet, when inflation is high or rising, value stocks have tended to outperform growth, as has been the case year-to-date.
Another example is with various types of bonds. Not all of them are ideal across all conditions. We want to own diverse bonds as well that can complement each other over time and across various inflationary rates.
In short, if you’ve not yet done so, it’s time to define your financial goals, and build your personalized, globally diversified portfolio to complement them. If you’ve already completed these steps, you should be positioned as best you can to manage higher inflation over time, which means your best next step is most likely to stay put. This brings us to our next (and I believe, most important) point …
Stocks vs. Inflation: It’s a Knock-Out
Provided time is on your side, the stock market is your greatest ally against inflation.
Over time, global stock market returns have dramatically outpaced inflation. For example, as reported by Dimensional Fund Advisors in this 2018 article regarding inflation, $1 invested in the S&P 500 Index from 1926–2017 would have grown to $533 worth of purchasing power by the end of 2017, after adjusting for inflation. Had that same dollar been held in “safe” one-month Treasury bills over the same period, it would have grown to an inflation-adjusted $1.51.
That T-bill growth is not nothing, especially because it’s a welcome relief during bear markets. That’s one reason we advocate for maintaining an appropriate mix between wealth-accumulating and wealth-preserving investments. But what’s “appropriate”? It depends on your personal financial goals. The point is, as long as you have enough time to let your stock allocations ride through the downturns, you can expect them to remain well ahead of inflation simply by being in the market.
And as I’ve always reminded clients, it’s important to add that no market-timing moves are required or desired when participating in the stock market. In fact, moving holdings in and out at seemingly opportune times is more likely to detract from the vital, inflation-busting role stocks play in your portfolio. In the words of Nobel Laureate Eugene Fama: “The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.”
What If You’re Retired?
So far, so good. But not all your wealth is for spending in the far-off future. What if you’re depending on your portfolio to provide a reliable income stream here and now? If you’re retired, (or you have other upcoming spending needs such as college costs), eventual expected returns offer little comfort when current inflation is eating into today’s spending needs.
Again, you can’t control inflation, but you can manage your own best interests in the face of it.
Engage in Retirement Planning: Along with a globally diversified investment portfolio, you’ll want a solid strategy for investing for, and spending in retirement. For example:
–Tax Efficiency: Among your taxable and tax-favored accounts, where will you place your stocks, bonds, and other assets for tax-efficiently accumulating and spending your wealth?
–Spending: How much can you safely withdraw from your investment portfolio to supplement your other income sources (such as Social Security)?
–Withdrawal Strategies: Which accounts will you tap first, and then next?
Revisit Your Retirement Planning: Especially when inflation is on the rise, it’s worth revisiting your existing investment and withdrawal strategies. What are the odds your current portfolio won’t deliver as hoped for? We typically use odds-based “Monte Carlo” simulations to ask this critical question, and guide any sensible adjustments the answers may warrant.
Don’t Panic: What if inflation is taking too big a bite? A common misstep is to abandon your carefully structured investments in pursuit of short-cuts. For example, it may be tempting to unload high-quality bonds and pile into gold, dividend stocks, or other ways to seek spendable income. Unfortunately, we believe such substitutes detract from effective retirement planning. The goal is to optimize expected returns and manage unnecessary risks in pursuit of a dependable outcome.
Have a “Plan B”: What can you do if a worst-case scenario is realized? Are you willing to cut your spending to a pre-determined level? Could you downsize to a smaller home? These types of questions are at least worth discussing so that if something terrible does happen, you have that plan to fall back on. The odds might be very low of needing to take drastic action, but this can help you to feel more comfortable when we experience regular turbulence.
How Can We Help?
While anyone can embrace the strategies we just described, implementing them can be easier said than done. Plus, there are more steps you can take to defend against inflation such as engaging in additional tax planning, possibly tapping lines of credit like a second mortgage, optimizing Social Security benefits, and more.
As always, feel free to reach out if you’d like to discuss these and other retirement planning actions and how they might affect you personally. After all, making the most of your possibilities is always a smart move, whether inflation is here to stay or not.
Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed in this newsletter.