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Inflating Your Investment Options

Is inflation going up? Are we likely to see deflation instead? Will we continue the current environment of low inflation? The jury is still out. Still, it’s not too early to begin educating yourself as to what investments you may want in your portfolio given each economic possibility.

Even if you have a diversified portfolio of stocks and bonds, the wrong investment mix could cost you upwards of 2% a year. This is according to an article by Peng Chen, “The Inflation Scenario,” in the September 2010 issue of Financial Planning.

If we have an extension of the current environment where the inflation rate stays under 2%, this favors a more traditional mix of global stocks and bonds.

A prolonged “Japanese” style deflation, where prices decline year after year instead of climbing, presents a different challenge. In this case stocks, commodities, and real estate will probably do poorly while government bonds are the better choices.

However, if we return to a more normal economy where inflation averages 3.5%, the Chen study suggests that in addition to the normal mix of global stocks and bonds you will want to add commodities to your portfolio.

Many economists fear it is politically impossible to raise taxes or cut spending enough to significantly retire our nation’s debt and that the government will employ a third leg of debt reduction, inflation. In a period of high inflation, the asset classes that will probably do best are commodities, inflation-adjusted bonds like TIPs, and real estate. To the degree that the dollar sinks against global currencies, foreign stocks and bonds may outshine their domestic counterparts.

This leaves two big questions. What scenario will play out over the next ten years? And how will you know it’s happening before it’s already old news? Unless you follow current events very closely and have a little training in economics and a lot of luck, you won’t.

In my 30 years of investment experience, the strategy I’ve seen work the best is having a wide variety of investments that do well in a variety of economic scenarios. Then keep your hands off except for periodic rebalancing. While this strategy means that in any given year you will always have winners and losers in your portfolio, over the long run the odds are good that you will do fine.

Chen’s study found that from 1970 to 2009, a portfolio with a minimum of 10% to a maximum of 30% in each of six asset classes (US Stocks, International Stocks, US bonds, TIPs, T-Bills, Commodities) out-performed portfolios that did not have commodity exposure.

While this allocation underperformed a more traditional allocation of stocks and bonds in a low-inflation environment by about 1.5%, it outperformed it by about 2% during times of moderate to high inflation. If you believe moderate to high inflation is in our future, you will seriously want to consider a portfolio similar to Chen’s.

Selecting a good mix of investment classes doesn’t have to be difficult. If you are in your employer’s 401(k) or a similar retirement plan, it’s possible that every asset class you need is represented among the plan’s investment choices. If not, ask your employer to add the missing asset classes. Commodities, TIPs, and real estate funds are most likely to be missing.

If educating yourself about investment options seems too challenging, don’t rely on a co-worker or your employer to select your retirement fund’s asset classes. If you need to delegate investment decisions, consult a registered investment advisor who holds a CFA or CFP® designation. This task is too important to your future financial health to be done blindly.

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2 Responses to Inflating Your Investment Options

  1. Rich Colman March 28, 2011 at 4:28 am #

    Rick:

    Great job here!

    I love the idea of discussing the 3 scenarios of deflation, such as Japan, normal growth as we experienced and then a return to out of control inflation similar to the 1970s.

    This piece is a great summary and is something all investors and even workers and retirees should read!

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