The Investment Scientist

How to protect your portfolio against inflation?

Posted on: March 11, 2010

Inflation is the silent killer of wealth. It does not have the “bark” of a full-blown financial crisis, but it certainly has the “bite.” Just imagine if the inflation rate is 4% over the next 10 years; within a decade you would lose nearly 40% of your wealth if you didn’t do anything about it.

Inflation over the next decade is highly probably because of two simple macro realities:

  1. America – from the federal government to the states down to individual households – is heavily in debt. The easiest way to get out of debt is to print money. There is a tremendous political incentive to do so.
  2. China, which has been the low-price setter for the past two decades, has seen labor costs galloping at a 20% to 30% annual clip lately (thanks to the one-child policy). Before long, that will translate into higher prices at your local Walmart.

To understand how to protect your portfolio against inflation, let’s examine the correlation between inflation and the following asset classes:

Asset class Correlation with inflation Return volatility
Stocks 2% 20.53
Long-term government bonds -15.1% 6.09%
Treasuries 1-year 18.1% 5.23%
Treasuries 1-month 41% 3.27%
TIPS 48.3% 6.68%
Gold 40.3% 38.1%

Data source: Lee and Lee, Dimensional Fund Advisors.

Assets that have high return correlations with inflation will hold their value better than assets that do not. So, at first glance, gold, TIPS, and short-term Treasuries (especially 1-month Treasuries) are good inflation hedges.

At closer look, gold appears less attractive because it is highly volatile. The volatility of inflation is about 4%; gold has a return volatility close to 40%. Using highly volatile gold to hedge inflation is like using chemotherapy to treat the common cold. I am not sure which is worse, the “treatment” or the “disease”?

On the other hand, long-term bonds are clearly bad in an inflationary environment. Unfortunately, long-term bonds are in many investors’ portfolios since they have higher yields than short-term ones. (Financial advisors like to use them as well since the additional yields make them look smart.) When inflation rears it ugly head, these investors will get a nasty surprise: their bond value will drop like a rock just when money itself is worth less. If you don’t want such a nasty surprise, order my portfolio review.

2 Responses to "How to protect your portfolio against inflation?"

Thanks for the nice article.
Its rocking.

You are welcome.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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