- High valuations of stocks and low yields on bonds mean the next decade will be challenging for investors to protect the real (after-inflation) value of investments.
- An investment portfolio of all equities will likely outperform inflation over time, but would be volatile. Think about a reliable source of liquidity such as a portfolio of cash and cash equivalents, like very short-term, high-quality bonds.
- The traditional 60/40 portfolio will likely neither grow in excess of inflation nor provide much downside protection.
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In the long run, inflation is an investor's biggest threat.
Inflation erodes the purchasing power of money. Even modest inflation at 3% annually halves the value of money in 24 years. So outpacing inflation is the primary goal for long-term investors.
Beating inflation was not a problem over the past decade. Stocks soared 360% in the past 10 years, averaging more than 16% per annum. No wonder valuations are near record levels. Bond yields, low to begin with, have fallen further over the decade: 10-year Treasurys yield just over 1%, municipal bonds less than 1%.
Outpacing inflation over the past decade was easy for investors, but the high valuations of stocks and the low yields on bonds means that the next decade will be much more challenging for investors to protect the real (after-inflation) value of their investments.
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Today, high-quality bonds, a mainstay of most portfolios for their consistent yields and downside protection, offer neither yield nor an inflation hedge.
Adjusted for inflation, yields on high-quality bonds are negative.
In other words, investing in Treasurys is guaranteed to earn a full 1% less than inflation over the coming decade. Investors in Treasurys are guaranteed to lose value as will investors in municipal bonds and even in high-grade corporate credit.
Many investors may ask: "Don't high-quality bonds provide protection during an equity sell-off?" The answer is: "Not anymore." With yields so low, bonds can no longer rally when stocks sell-off.