Bolting the Doors Against Inflation

A thief is a wealth destroyer against which we can take obvious precautions, such as locking the doors to the house. Adding an alarm system helps, too. But inflation is a much more insidious villain that requires a subtler defense.

Inflation acts as a hidden tax that doesn’t show up on your annual IRS return. In many ways it is a tax, because it largely results from flawed monetary or fiscal policies. We can “insure” ourselves against the effects of that stealth tax, but it can be tough to decide just how much insurance is necessary. Determining an appropriate portfolio allocation depends largely on where you are in life, your long-term goals and how much risk you can tolerate.

For instance, those in their 30s with at least another 20 working years ahead of them can afford to carry less inflation insurance. Their steady income provides a built-in inflation hedge, particularly if they are fortunate enough to receive at least an annual cost-of-living increase in their wages, and their 20 years of human capital should help them make up any losses.

Those in their late 40s to early 50s, however, must be much more concerned about the potential impact of inflation because they have fewer working years ahead of them. Inflation protection should be a paramount concern for someone in retirement who depends on a fixed income and savings for their financial security.

The trick at any age is determining just how much of your investable assets to allocate to inflation hedging, given that it should be a progressive process. Too small an allocation is no help and overweighting can do more harm than good. As with any specialized investment strategy, it simply shouldn’t consume your entire portfolio because inflation tends to run in cycles.

Consequently, the inflation hedging sleeve of your portfolio should fall somewhere between 10 percent and 20 percent of your investable assets.
Younger investors should allocate at least 10 percent of investable assets to hedging, including a mixture of large- and small-cap stocks, foreign equities, some shorter-term bonds and a smattering of alternatives such as real estate investment trusts and commodities.

As they progress through their investment life cycle, they should gradually step up their allocation a few percentage points every few years, until reaching 20 percent at retirement. And while it’s impossible to be perfectly prescient in the short term, if the long-term inflation trend is running over 5 percent annually it would be worthwhile to increase your allocation until inflation slows back down.

Bank loans perform well in stable inflationary environments, thanks to steady economic growth and stable interest rates that make debt service an easier proposition. When inflation heats up, bank loans become slightly riskier because higher interest rates can trigger an uptick in default rates. Regardless, on average bank loans still return better than 5 percent.

The best performers in the midst of an inflationary spike are energy stocks, basic materials and commodities.

In times of stable inflation, energy stocks typically return about 10 percent as demand grows steadily along with the economy. Materials stocks and commodities usually average returns in the mid-single digits, largely due to the same underlying trends.

But as inflationary pressures build, so do their returns. That’s largely because spikes in commodity prices—due to generally higher demand and investors flooding into real assets—drive commensurate spikes in returns.

By including an inflation-hedging sleeve within a balanced portfolio, you help to ensure solid returns in times of both stability and peril without adding substantial additional volatility to your portfolio. If you make too small of an allocation, you realize little to no hedging benefit, while an overweight allocation can create performance p! eaks and ! valleys that just aren’t worth the sleepless nights.