As the U.S. economy speeds optimistically toward what feels to be a strong recovery from the global impact of the coronavirus pandemic, the discussion has naturally turned toward the fear of the economy overheating and exhausting itself. In step with this thought is the concern of inflation, which is a decline in purchasing power over time.

A traditional theory among economists is that inflation can be caused by a country’s money supply growing out of pace with its underlying economic growth. Some inflation is good: It encourages consumers to spend money today. But too much money circulating in the economy causes a currency to lose its value as prices rise to meet consumer demand and subsequently reduce the amount of goods and services that a given unit of currency can purchase.

Inflation is commonly measured through the consumer price index (CPI), which measures the change in the price paid by consumers for a basket of goods and services. Think food, transportation, utilities and medical care.

In his May 13 Investor Update, AAII Journal editor Charles Rotblut shared that the CPI rose more than expected in April: It was up 4.2% before adjustment on a 12-month basis, which was the largest 12-month increase since September 2008.

So, the current inflation concern is rational. Any time in history when a nation has seen a dramatic increase in available cash, inflation has been a concern. In the 1920s, John Maynard Keynes wrote in “A Tract on Monetary Reform” that inflation’s “most striking consequence is its injustice to those who in good faith have committed their savings to titles or money rather than to things.” Keynes saw that inflation often hurts investors the most, while businesses and wage earners receive potential benefits from an increase in the cost of goods and services.

We are seeing these forces play out in our current economy, according to economist Larry Summers in a recent column for the Washington Post. “Wages and productivity growth are increasing,” as the U.S. economy outperforms that of other industrial nations.

Impacts on Your Portfolio

As rational individual investors, what are we to do with the implications of inflation on our portfolios? The first step is to recognize any fears we have toward achieving our investment goals. The key to getting through an inflationary period is the same key that unlocks long-term portfolio returns: following an asset allocation that reduces risk through diversification.

Your asset allocation will depend on where you are in your investment timeline and your tolerance for risk. As investors age, they generally move from aggressive to moderate to conservative asset allocations based on their needs. With a short-term horizon of 10 years, AAII’s conservative asset allocation model favors fixed-income investments to ensure a steady supply of cash when needed. Its mix is 60% fixed-income and 40% diversified stock. This contrasts with the aggressive asset allocation model’s mix of 10% fixed income and 90% diversified stock.

As Keynes pointed out in “A Tract on Monetary Reform,” inflation burns investors holding cash and fixed-income assets, as the purchasing power of cash goes down and fixed-income bonds are paid back with the devalued cash. If you are primarily invested in a diversified portfolio of stocks, short-term inflation concerns shouldn’t be a worry of yours. Stocks are historically a hedge against inflation due to their growth prospects.

However, you should note that during periods of high inflation, the return on stocks can be significantly different after inflation is accounted for. This is the difference between nominal (before inflation) and real returns. Craig Israelsen wrote an excellent deep dive into the effects of inflation on different asset classes in “Inflation: The Dormant Dragon” in the September 2020 issue of the AAII Journal—for those interested in a data-driven, historical overview.

Strategies to Diminish Inflation’s Impact

For investors following a similar conservative asset allocation favoring fixed-income assets, there are strategies to mitigate the risks of inflation. One is to include dividend-paying stocks in the equity portion. Over time, dividends have grown at rates faster than inflation. In the July 2020 issue of the AAII Journal, Aaron Brask discussed the empirical evidence behind this idea in “Dividend Growth Helps Portfolio Combat Inflation.”

Real estate investment trusts (REITs) can also work in a rising inflation environment, depending on interest rates. The Federal Reserve’s tactic to fight inflation is to raise short-term interest rates. Raising the cost of borrowing money in the short term reduces the excess capital in the economy causing inflation. As of yet, the Fed hasn’t announced plans for rate increases.

Another strategy includes laddering the maturity of bonds or certificates of deposit (CDs) to reduce timing risk. This involves buying bonds or defined-maturity bond funds (or CDs) with different maturities. This will mitigate interest-rate risk, increase liquidity and diversify credit risk.

The U.S. Treasury also offers inflation-protected securities (TIPS). Investors can buy these directly at Treasury Direct or indirectly through mutual funds or exchange-traded funds (ETFs).

There’s always gold, too, but it does not always live up to its historical reputation as a hedge against inflation. Keynes wrote against a return to the gold standard for countries looking to stabilize their currencies during the 1920s. At that time, countries were cycling through severe periods of inflation and deflation. Our economies and monetary policy have advanced quite a bit since then, as well as our investment options.

Conclusion

With all of these strategies to think about, it is important to remember that we don’t know what inflation will look like in 12 months, or in five or 10 years. Making large changes to your portfolio based on short-term data isn’t advisable, especially if you have an asset allocation strategy worked out. On top of that, most economic indicators are retrospective—such as inflation—or lagging. If the economy tipped toward a recession because of inflation, we wouldn’t know until we were already in it.

Economics’ retrospective nature was a frustration of Keynes’ own investment portfolios, which crashed multiple times over his lifetime. But we have collectively learned quite a bit from Keynes’ writing, notably to stay the course via diversification.

But it is important to sleep at night, too, so small tactical changes as outlined in this article may be appropriate if they lower your stress. Just remember that you’re trying to predict inflation and the markets in a field that is based on retrospective observations. There is a lot of potential for economic growth with the end of the pandemic appearing to be around the corner.

Keep in mind what Keynes said in a memo sent to directors of the National Mutual Insurance Company where he managed investments during the Great Depression: “Some of the things which I vaguely apprehend are, like the end of the world, uninsurable risks and it is useless to worry about them.” 

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