It is said that inflation is an insidious thief. It creeps in and slowly erodes the value of financial assets. While its effects may seem subtle in the moment, over time the impact of inflation can have serious deleterious consequences for financial planning and investment returns.
At KFG, we create highly tailored financial plans for our clients. They are grounded in rigorous analysis and further informed by stress-testing portfolios. That is systematically shocking the long-term cash flows affected by many factors including inflation, taxes, interest rate term structure, economic growth and investment returns.
You could say our approach to financial planning is forensic. It is also clinical, psychological, and deeply experienced.
Last week, I briefly wrote about COVID and the sharp rise in prices throughout 2021. While higher inflation was broadly anticipated, there is widespread disagreement about how it will manifest going forward. Most concerning is that inflation could spiral out of control.
The rebound in energy prices and the disruption of the global supply chain are two primary factors driving inflation. Both are born out of the COVID-19 global pandemic. Low vaccination rates and dangerous mutations of the COVID-19 virus such as the Delta and Omicron variants have further complicated economic forecasts.
We can’t predict what will happen with inflation or the economy. However, we can stress-test our portfolios to understand the impact of inflation and other factors to returns.
No doubt a spike in inflation would have a short-term negative impact on most financial assets; especially inflation-sensitive asset classes such as bonds and cash. It could also have a negative impact on economic growth, corporate earnings, and investor and consumer psyche. Ultimately it could lead to a recession.
We found that if this scenario were to play out in 2022, the traditional 60/40 portfolio of stocks and bonds would likely lose between 30%-34% of its value. Our average portfolio of similar risk would likely lose between 18%-22%. Not good, but significantly better than the traditional 60/40 approach.
We also stress-tested our strategy against real historical scenarios. We looked at past economic cycles, including stagflation from the 1970’s and high inflation during the Iranian Revolution of 1979. We found that, while in every negative scenario our portfolio lost value, our risk-balanced investment approach performed meaningfully better than the traditional 60/40 portfolio of stocks and bonds.
We found that recessions resulting from significant excesses caused the most harm to portfolios. The worst cases include Japan’s lost decade, the Dotcom bust of 2000 and the Financial Crisis of 2008.
Research shows that over the long term, investment returns exceed inflation. Having a thoughtful financial plan and simply staying invested over the long run will further improve outcomes.