Is Your Portfolio Protected Against Inflation?
Inflation protection is more concerning for some investors than others.
The following is an excerpt from Christine Benz’s recent webcast, Tune Up Your Portfolio in Uncertain Times. Watch the full webcast.
“The next step in the process is to evaluate inflation protection, so to think about how insulated your plan is from inflation. And I think that this is certainly top of mind for investors right now. We've seen the most recent inflation reading at 7%, its highest rate in decades. And this necessarily has a lot of consumers, not just investors, has a lot of consumers spooked about what this means for their plans. I would say that inflation tends to be most worrisome for retirees. For workers, workers right now are in a really strong job market. Many employers are making workers whole in terms of inflation, where they're giving out nice raises, they're giving out cost-of-living increases. Retired workers who are pulling part of their cash flows from their portfolios, I think necessarily are more concerned because the portion of their portfolios that they're withdrawing to cover their living expenses aren't inherently inflation-protected. So, I think that they have reason to feel a little bit more cautious during this period.
I do think it's important to think about your own situation, to think about your own income sources when deciding how worried to be about inflation. So, if you're a worker, if you're getting strong increases in terms of your paycheck, then you're relatively insulated from inflation. Your cost-of-living increases may not be entirely keeping up with inflation, and that's something to think about. But nonetheless, over time, we do tend to see salaries keep up at least on some level with inflation. On the other hand, people who are pulling withdrawals from their portfolio, that's the group who I think needs to be the most cautious. And so, you'd want to be especially cautious if you are someone who is pulling your withdrawals from your portfolio and a healthy share of that portfolio is parked in fixed-rate investments that don't necessarily keep pace with inflation. So, the most vulnerable of all would be the person who is relying on his or her portfolio for a big share of his or her income needs, and that portfolio is parked in very safe assets. So, it's parked in CDs, it's parked in nominal bonds. That's a person who would need to be more cautious and more thoughtful about making sure that they're putting in inflation protection for that plan.
So, how do we make sure that our plans, that our portfolios, have inflation protection? I think you want to look to a couple of key assets. At the top of the list for people who are in drawdown mode, so for retirees, that would call for having a healthy allocation to what are called inflation-protected bonds. These are bonds where you receive a little bit of a nudge up to account for inflation. And so, Treasury Inflation-Protected Securities are a variety of inflation-protected bonds. I-bonds are another variety of inflation-protected bonds. If you're someone who is in retirement and you have fixed-rate investments in your portfolio, I would augment them with a component of inflation-protected bonds.
Another way to protect against inflation, to defend against inflation over time, is to make sure that our portfolios have ample stock exposure. I always caution people that stocks are by no means an inflation hedge. So, if inflation goes up 7% this year, we won't necessarily see stocks go up 7% this year. But one thing we know is that over long periods of time, stocks do tend to outearn inflation, which is one reason why it makes sense even for retirees, even for older retirees, I think it makes sense to hold a healthy sleeve of equities in their portfolios. And certainly, for younger investors, one of the main ways you defend against inflation is by asking for those cost-of-living increases and then within your portfolio maintaining ample stock exposure.
There are other, what I would consider sort of niche, ways to obtain inflation protection. So, you might look at real estate investments, either real estate investment trusts or direct real estate ownership. One thing we know about those assets is that when inflation is high, that's usually when landlords or real estate owners can push through increases. You might also look to a category like commodities. I have to say that I'm a little bit lukewarm on the category in part because investors have historically used commodities so poorly. They bought them at exactly the wrong times. But that's another category. When we look at the categories that tend to do hedge fairly well against inflation, commodities do a decent job.
On the bond side, we also see some inflation protection being conferred through categories like bank-loan or floating-rate investments. To a lesser extent, high-yield bonds also appear to be somewhat protective in an inflationary environment. And we were showing on earlier slides how high-yield bonds tend to be less vulnerable in the face of rising interest rates. That's often an inflationary environment. So, high-yield bonds tend to do relatively better in those environments. So, those are some categories to be thinking about as you evaluate your portfolio's protection against rising inflation.”
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