For Inflation Protection, Stay the Course, Diversify

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference.

What is the first thing that comes to mind when you hear the word inflation? For Morningstar's Jeff Holt, associate director of multiasset manager research, it is a memory of childhood amazement. How could one receive $25 for a chore he had performed not a year earlier for just $20? For many investors, the concept may conjure up something a bit more sinister.

The negative impact of inflation on real wealth is simple--when the things you buy on a regular basis cost more, you can afford less of them with the same number of dollars. It's a huge implication, especially for those eyeing a retirement nest-egg and wondering whether the balance is adequate.

As part of the outcome-oriented investing series at the 2017 Morningstar Investment Conference, Holt sat down to discuss what inflation means to asset managers and how they plan to protect investors' purchasing power. He was joined by Jessica Bush of Principal Financial Group, Research Affiliates' Michael Aked, and Ken Baumgartner of Wellington Management.

Asking three professional managers of inflation-protection strategies to weigh-in on the importance of inflation protection is a bit like asking your barber if you need regular haircuts. The panel's answers to the importance of inflation protection is a foregone conclusion, so instead they focused not on if investors need protection, but how can they get it. How should investors grappling with inflation concerns proceed?

One fact was immediately clear: Inflation, and by extension, inflation protection, is a broad, complicated concept. Every factor that influences inflation can be countered to some degree with an inflation-protecting asset class. TIPS work well thanks to their contractual link to price levels, but can work better in tandem with other assets over time, said Bush. Panelists warned investors to closely monitor TIPS exposure, so duration sensitivity of the bonds does not outweigh inflation sensitivity.

Panelists labeled commodities the "purest" form of protection because prices immediately reflect the effects of a changing environment. Aked went as far as to suggest that literally any asset outside of the stocks and bonds of developed economies will serve as an inflation buffer over the long run. The longer the discussion lasted, the clearer the following became--no one asset class perfectly addresses all sources of inflation, at all times.

What is the logical conclusion when the experts tell you that inflation protection always has a place in your portfolio and that no one asset is a silver bullet? Diversify, and stay the course. Aked believes an investor can get 90% of the benefit by doing 10% of the work, just by allocating a sleeve of assets to a diversified portfolio of inflation protecting securities, and rebalancing annually. Not a bad benefit/effort ratio.

Baumgartner echoed the stay-the-course-mentality, positing that, when stocks and bonds are generally performing well, many of these inflation-linked securities will underperform. Investors tend to misuse by buying high and selling low, so avoid the temptation to time the market. Choose a diversified source of inflation protection (but don't overpay), rebalance diligently, and remember to tie your grandchild's lawn-mowing compensation to the Consumer Price Index.