How to Factor Inflation Into Your Investment Portfolio

The topic of inflation and its far reaching impact on the economy has dominated the news in recent years. Though a hot topic now, inflation is nothing new; back in the 1970s and early 1980s, inflation was at an all-time high (peaking at 14.8%), causing food and fuel prices to go up and President Ford to declare inflation as “public enemy number 1.”

While inflation is keenly felt at the gas pump and grocery store, it can have a more insidious effect on your investment portfolio. Your investments can be seriously impacted by inflation – unless you take steps to mitigate its effect.

In this article I discuss inflation – what it is, its causes, and what you can do to try to minimize the risk to your investment portfolio, helping to give it a chance to better withstand a prolonged inflationary environment in the future.

What is inflation?

Inflation is the economic term for a persistent and broad rise in prices over time (or the decrease in value of money over time). It is largely influenced by supply and demand. For example, when there is a higher demand for products and services than what the economy can provide, the prices for these tend to go up. Conversely, when there is less of a need for a product or service than what the economy is supplying, costs typically go down (also known as deflation).

What factors can cause inflation?

The cause of inflation can’t be boiled down to one economic factor; however, in recent years, certain issues and trends have the potential to cause inflationary surprises. Here are a few to monitor:

• Geopolitical unrest

  Geopolitical instability can have devastating effects on the supply chain, particularly in terms of raw materials and finished goods. In times of geopolitical turmoil, suppliers are often unable to operate as normal due to disruptions in transportation networks and other logistical issues. Less access to supplies and the increased demand leads to inflation. For example, with the vast majority of advanced semiconductor manufacturing taking place in East Asia, geopolitical unrest has the potential to make all goods produced with computer chips more expensive in price if global supply chains were to become disrupted.

• Money printing

  When governments increase the amount of money in circulation by issuing currency through economic stimulus programs, this can reinforce the cycle of rising inflation. Although the hope is that adding more money will encourage people to spend and borrow resulting in economic growth, if the money isn’t spent, businesses won’t be able to sell their products, prices get raised and ultimately, money loses value.

• Deglobalization of supply chains

  The practice of reshoring can lead to increased production costs for labor. Globalization over the past several decades has been a deflationary force due to the substantial efficiency gains brought about by lower cost labor abroad. National security concerns that lead to governmental or corporate policies of nationalization and deglobalization may threaten these embedded deflationary efficiencies. Increased costs to produce the same goods and services domestically, may be transferred from the company to its consumer in the form of higher prices for those goods and services.

• Decarbonization

  Decarbonization, or global clean energy initiatives – as warranted as they may be – can lead to inflation because it requires significant investments in new technologies and green infrastructure. These required investments can increase the cost to produce goods and services, which can in turn lead to higher prices for consumers.

How can I create an investment portfolio that reduces the risk of inflation?

History has shown us that short-term inflation surprises don’t tell a 30-year story. When allocating your assets in retirement, it’s important to create a holistic “insurance” plan that attempts to hedge against the threat of higher inflation over a 30-year period of time. Adopting this risk management mindset allows investors to create a portfolio that will minimize risk, potentially increase gains, and perform well if a persistent inflationary environment were to otherwise threaten your retirement spending.

In my experience, there are three key factors you must consider when looking to diversify your assets.

1. Diversify your bond portfolio.

A bond is a contract between two parties. When you purchase a bond, you lend money to the issuer whether it be the government, municipality, or a corporation. In return, the issuer promises to pay you a specific rate of interest during the life of the bond and repay you the principal when it “matures” or comes due after a set period of time.

To build a diversified bond portfolio, you need to consider both the maturity of the debt as well as the type of debt. Here are some things to consider:

• Be mindful of when to purchase. 
  Whether your strategy is to buy and hold bonds until they mature and collect principal and interest, or to sell it early and make a profit, it’s important to be aware of timing. Keep in mind that rising interest rates can affect future earnings and that though you may “lock” your bond in at a good rate at the time of purchase, it doesn’t protect you against inflation later.

  To manage this uncertainty, many bond investors “ladder” their bond exposure. This means that investors will buy multiple bonds that mature across a span of years. As their bonds mature, they reinvest the principal and the ladder grows. This strategy helps to diversify interest-rate risk in your portfolio.

U.S. Treasury Bonds and Notes Ladder Yield Curve
The longer the duration, the more exposure to the risk of higher-than-expected future long-term inflation.

• Consider your long and short-term financial goals. 
  Different bonds have different maturity dates. Some mature next year, while others mature in 30 years. If you buy a 30-year bond when rates are low, and in 2 years inflation causes rates to spike, you’re still tied into the low rate; the income you receive from this bond will not go as far as you had originally hoped at the grocery store or gas pump. This is known as inflationary risk.

  A good rule of thumb at the time of purchase is to remember that the longer you tie your money up into a fixed income instrument (e.g., bond), the more this investment is at risk to the threat of higher future inflation.

Chart demonstrating inflation a 60-year span
 Source: World Bank

• Consider the best bond for your own investment portfolio. 
  Your risk tolerance, tax situation, and time horizon are all factors that could influence your decision on investing in a certain type of bond. If you allocate well, you could hold different types (U.S. Treasury issues, Certificates of Deposit (CDs), and municipal bonds) which will diversify your portfolio and reduce credit risk. As discussed above, staggering the maturities can reduce interest-rate risk as well.

2. Invest in stocks – especially those that may perform well during inflationary environments, such as companies that own real assets.

Stocks in general have historically been effective at passing through rising costs to their customers and therefore have been decent at keeping up with rising inflation. In theory, a company’s revenues and profits should grow with inflation after a period of adjustment. In addition, the stock market also includes companies that own and produce “real assets” that may be supportive during inflationary periods, such as:

• Real estate
• Infrastructure
• Industrial products
• Construction
• Raw materials

Companies that invest in and produce real assets may add diversification, stability, and the potential for higher returns during inflationary periods.

3. Monitor the profitability of growth companies in your portfolio

When looking at investing in a company you must weigh two important components: current profitability vs. future growth. Is the company profitable currently, or does its price factor in long-term growth in the future? To simplify, pricing in many future years of earnings is similar to locking in a long-term bond – it is at greater risk to an inflationary environment and rising interest rates. This is why you need to pay close attention to the companies in your portfolio that are currently unprofitable, such as growth companies.

Famous historical examples of growth companies include Google, Tesla, and Amazon; there are many more lesser known ones on the stock exchange.

During times of high inflation, growth companies can experience significant draw downs due to the rise in interest rates and the re-pricing of their future earnings. Moreover, since growth companies tend to burn through money, they need to make sure they can borrow money when it’s needed. Higher interest rates tamp down borrowing, which means the growth company has a harder time actually growing into its future projected earnings. The estimates on its long-term earnings are reduced, and its value drops.

This doesn’t mean you have to remove growth companies from your portfolio completely; it means you need to be mindful about how much you allocate to growth companies when constructing your portfolio for the possibility of higher-than-expected future inflation during retirement.

In Conclusion

Consider an asset allocation that is an appropriate balance of stocks and bonds. Make sure that it reflects your goals and the amount of risk you’re willing and able to take on. As time goes on and the market ebbs and flows, it’s important to stay the course and not make decisions based on emotions. Hedging inflation concerns at the onset will allow you to remain clear-headed and focused on the long-term and will be the best way to maximize your chances of never having to worry about money during retirement.

Toberman Wealth is a fee-only, independent fiduciary firm based in St. Louis. We operate in the best interests of our clients, always. Our priority is to help you live comfortably now, without sacrificing your financial future later.

If you are looking for an investment advisor to help you build a sound strategy for your portfolio, feel free to book a meeting or give us a call.

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