The impact of today’s inflation on portfolio construction
Inflation is a phenomenon that affects all investors. One of the wealthiest individuals in the world, Warren Buffet, once called it “a very cruel tax.” If inflation is painful enough to cause Buffett to weigh in, investors across asset levels can be sure they’ll also feel its effects during economic uncertainty.
But taking a proactive approach to portfolio construction while evaluating individual financial goals and outlooks can help mitigate some of inflation’s most severe effects and position a portfolio to capitalize on the next economic cycle. That’s why advisors need to monitor and manage portfolios during periods of high inflation carefully, guiding their clients to invest in the right mix of assets and sectors so that they can preserve buying power and emerge intact when economic conditions normalize.
The varying effects of inflation
Inflation affects different aspects of a portfolio with varying intensity. For example, during periods of historically high inflation, stock-bond correlations tend to rise, offering investors fewer places to ride out the storm. But when inflation is more moderate, negative stock-bond correlations can help diversified investors to grow and protect their wealth.
Although they’re more volatile, equities tend to successfully manage periods of inflation over the long haul because companies have power over their pricing and can adjust earnings upward over time. Moreover, even though equities are more volatile, specific sectors tend to outperform others during periods of high inflation.
With costs tied to inflation, energy and other commodity-linked companies can better keep up with inflation, helping them maintain their valuations relative to tech and growth-oriented firms that are more sensitive to the rate increases used to tamp down inflation. There’s also the issue of demand: consumers can’t readily stop purchasing things like electricity, food, or gasoline, while they might trim their spending on new vehicles, electronics, or vacations.
While they’re typically a more stable investment, the returns generated by bonds tend to suffer during high inflation. Because bonds are debt-based, they’re typically locked into a specific interest rate. When interest rates fluctuate rapidly as central bankers attempt to stall inflation, the real yield of fixed income drops, and investor returns become less valuable.
But because policymakers want to entice investors to hold certain types of debt, some bonds, like Treasury Inflation-Protected Securities (TIPS), provide returns that take inflation into account, limiting the erosion caused by inflationary economic conditions.
Investors often group real estate into the “alternative assets” category, but art, precious metals, and even some commodities can be included.
While subject to the characteristics of local markets and market conditions, alternative assets aren’t always correlated to stocks and bonds, providing diversification and the possibility for positive returns that outrun inflation, even during periods of intense economic uncertainty. As a result, many investors and advisors include alternative assets as a hedge against inflation and volatility, providing ballast and stability within a well-managed portfolio.
How to handle inflation
Unfortunately, no single solution for solving the chaos inflation can sow in a portfolio. Still, some allocations and strategies can position investors to weather the storm with confidence and grace.
Before making portfolio adjustments, one of the most important steps is to review a client’s financial objectives and ensure that each investment is aligned with accomplishing that goal. Investors with longer time horizons may not need to make drastic adjustments to their investments, while investors nearing retirement or needing access to liquidity sooner than later might need to reallocate and reconfigure their portfolios quickly.
Investors nearing retirement may decide that purchasing an annuity is more cost-effective than during periods of lower interest rates. Other investors may hold non-US currencies or invest in overseas enterprises where inflation is less severe.
Many investors rotate out of growth companies with minimal cash flow to fund these investments. These companies tend to be affected most by the high-interest rates accompanying periods of intense inflation, making them more likely to underperform than value- or consumer-stable-oriented firms.
Advisors designing portfolios should partner with a technology provider that can help rebalance and adjust asset allocations quickly and effectively. In addition, you should be working with a firm that’s built its reputation through various market cycles and worked hard to earn the trust of its clients and third parties across the wealth management industry.
At intelliflo, we provide seamless access to portfolio building and maintenance tools, a 24/7 online community that’s helped advisors navigate challenging investing environments in the past and present, and a marketplace for researching and purchasing products and services to enhance your client offerings. To learn more, schedule a demo today.