Which Assets Can Jump the Inflation Hurdle?
Most investors think of their portfolio returns in nominal terms—the actual return on the investment without considering the impact of inflation. In a low-inflation environment, that way of thinking may not be particularly harmful.
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But when inflation increases, thinking in nominal terms can be very detrimental, especially to long-term investment planning.
With many investors now reconsidering their investment options, it is crucial to keep in mind the important distinction between real and nominal returns. The CFA Institute provides these tips on how to view different asset classes and their ability to keep pace with inflation:
- Cash and Short-Term Bond Funds: Cash investments, such as savings accounts and money market funds, will often yield less than the inflation rate, reducing a portfolio’s real return. While cash serves a useful purpose, it may be beneficial to consider a high-quality short-term bond fund to meet some liquidity needs. Remember, however, that returns that seem too good to be true often entail unexpected risks, so proceed with caution when reaching for higher yields.
- Bonds and Bond Funds: Medium- and longer-term bonds typically do poorly in periods of higher-than-expected inflation. That’s because inflation steadily erodes the purchasing power of a bond’s fixed-income stream. In addition, unexpected increases in inflation typically result in rising interest rates, which lower nominal bond prices.
- Inflation-Protected Bonds: Treasury Inflation-Protected Securities are an important exception to the behavior of most bond investments during inflationary periods. These bonds protect investors against unanticipated inflation explicitly, because they promise to pay a real rate of return plus actual inflation. However, even though TIPS offer protection against unexpected inflation, they share with conventional bonds the sensitivity to changes in interest rates and market sentiment.
- Stocks: Common stocks are generally thought of as good inflation hedges over the long term, since companies are able to charge higher prices to offset rising costs. Stock returns, however, are very volatile over shorter time periods, and may lag inflation over shorter-term horizons.
- Commodity Funds: Some investors may address concerns about inflation by investing in commodity funds, which have value that fluctuates with the prices of physical goods such as agricultural products, metals and oil. Actively managed funds within this category tend to concentrate on a narrow range of positions, and consequently can experience more volatile results compared to other types of funds. Additionally, some funds invest in companies that produce commodities, while others invest directly in the underlying commodity, which generally offers better diversification benefits.
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