- The best tool investors have to deal with inflation is perspective, which means looking at the big picture.
- How to gain perspective? Decide if your focus is short or long term.
- The assets most investors already use — stocks and bonds — offer the potential real returns that they will need, when perspective is correctly applied.
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Recent upticks in inflation have renewed interest from investors in assets that may help preserve the real (inflation-adjusted) value and purchasing power of their portfolio.
The good news is that the typical investor's portfolio will likely contain all the inflation-fighting tools that they need — such as stocks and bonds. However, the best inflation-fighting asset for an investor is actually perspective. That means taking a step back and looking at the big picture.
How can investors gain the perspective they need to contend with inflation? In my opinion, it starts with answers to two key questions: Is your focus on the short term? Or, is your focus on the longer term?
In short, the key for investors is to define financial goals and build a personalized, diversified portfolio to complement them.
For most investors, the purpose of their investment portfolios is to fund either current or future spending. Because many people expect the prices for goods and services to be more expensive in the future, they need to find ways to preserve their purchasing power and their assets need to grow at a rate at least equal to the rate of inflation.
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The most common assets used to provide this inflation-adjusted growth are stocks and bonds, and the real returns from these assets have well outpaced inflation over the long term.
Historically, higher returns and higher risk are well correlated.
Whether considering inflation-unadjusted (nominal) or inflation-adjusted (real) terms, common stocks provided higher average annual returns with higher risk than bonds. Both delivered higher returns and risks than Treasury bills, a proxy for a "risk-free" investment. Notably, T-bills have delivered negative real annual returns more often than either stocks or bonds.
Despite their low and often negative real returns, T-bills and other lower-risk assets, such as money market funds and shorter-term bonds, can serve an essential purpose for investors with short-term focuses. Because inflation's erosion of value is most significant over time, the longer the investment horizon, the more concerned one should be about the portfolio's future purchasing power.
Over the shorter term, the effects of inflation are less pronounced and even at unusually high inflation rates the vast majority of purchasing power remains intact. That makes principal risk a greater threat than inflation to portfolios with short time horizons: The worst annual U.S. inflation rate since 1926 was 18.1%, while the worst one-day loss for the U.S. stock market was 22.6% in October 1987.