(Disclosure: Some of the links below may be affiliate links)
Recently, inflation has started to climb again, especially in the United States. And many investors are worried about what this will do to their investments.
So, I want to talk about what we should do to our investments when inflation rises and what assets classes perform best when prices increase.
The return of inflation
First, let’s not forget that inflation never went anywhere. In the united states, like in most countries, inflation has been positive every year in the last two decades.
The change right now is that the United States published a 6.8% in December 2021. You can read about this in the official news release. It means that the prices of a given basket of items increased by 6.8% over one year. 6.8% is a significant number.
However, it is essential to note that between October 2019 to October 2020 (the previous measured period), inflation was only 1.2%. So, we only have one year of high inflation.
And we should take into account that a lot of this inflation is due to supply chain issues and the COVID recovery.
So, while 6.8% inflation is significant, we are not in a hyperinflation territory. There have been much higher numbers in the past. So, we should not worry too much.
Nevertheless, it is important to know how to invest in times of inflation.
What performs well in times of inflation?
To know how to invest in times of high inflation, we can look at the assets that historically performed best when inflation was high. I will take the United States as an example since it is currently the largest market.
Historically, real estate has been the highest performing asset in high inflation years. I am not talking about home price, but general Real Estate Investment Trusts (REITs) that heavily invest in commercial real estate and large development projects. On the other hand, U.S. home prices have kept up with inflation, but not more.
After this, international stocks have been second while U.S. Stocks have been third.
Does that we should switch to REIT when inflation starts? No! First, we have no way of knowing when we should change since inflation data would generally be too late. Second, we are usually interested in average or median real returns. Real returns are returns after inflation.
Here are the average real returns of asset classes from 1972 to 2021 (based on data from PortfolioVisualizer, here):
- U.S. Stocks: 8.38%
- REIT: 7.35%
- Gold: 6.38%
- International Stocks: 5.29%
- U.S. Bonds: 1.87%
- Cash: 0.71%
Often, median returns are more interesting, so here are the median returns:
- U.S. Stocks: 12.87%
- REIT: 9.00%
- International Stocks: 8.13%
- U.S. Bonds: 2.92%
- Gold: 2.45%
- Cash: 1.79%
If you are investing for the long term, you should generally not change anything to your asset allocation based on current events. On the contrary, your portfolio should be based on what you think will perform well in the future. And often, the only tool we have is historical real returns over long periods.
So, based on these returns, we should not switch anything because of inflation. Stocks have retained their value very well historically over the long term. There are have been very high inflation periods in the U.S. in the past (the 1970s, for instance), and stocks have kept up.
We can simplify this. Assets that provide fixed payments, like bonds, generally perform worse in times of inflation than assets based on monetary payments and can adjust to the price increases. For instance, most business will adapt their prices adequately and perform as well as usual. This fact is not always true, and very high inflation can also hurt businesses. But generally speaking, companies are faring well enough when prices increase.
Therefore, investing in stocks according to your proper asset allocation is still a good strategy. Of course, you should be diversified. You want stocks in many countries and industries. And if you are investing in the total stock market, you will also invest in REITs since many of them are listed in the stock market.
What about gold?
Gold is very often referred to as an excellent hedge against inflation. So, should we all own gold to prevent inflation?
Probably not. The previous section shows that gold average real returns are lower than stocks and median real returns are below 2.5% per year! These are not great numbers. So, investing heavily in gold would not have been great, except for some periods.
There have been some great periods for gold in the past. For instance, the 1970s have been great, with huge returns. And the 1970s was a period of very high inflation.
On the other hand, gold performed very poorly in the 1980s. During this period of medium inflation, gold real returns were negative. It means that investors would have lost money, not even kept up with inflation.
Gold can be a good investment, but it has not been a great inflation hedge in the last decades. Having some gold in a portfolio can make some sense. But I do not believe that investing heavily in gold will help, given its lower real returns.
What about debt?
In times of high inflation, debt is interesting. Since interest payments are generally fixed for several years, the real value of these payments will shrink over time.
So, in times of high inflation, it may make sense to take out debt to buy something that will retain its value, like real estate. You could even take out debt for stocks, but stocks are much more volatile, which would be significantly riskier.
I do not necessarily recommend taking out debt just because inflation is here. But taking a mortgage just before a strong inflationary period may be an excellent financial move. However, as already mentioned before, there is no way of predicting inflationary periods. Therefore, it comes more down to luck.
Currency exchanges and inflation?
Inflation may have an impact on exchange rates as well. It is especially important for us, European investors with a large allocation in foreign currencies in our portfolios. Therefore, currency exchange rates can play a significant role in our returns.
Generally, strong inflation hurts currency exchange rates. For instance, if there is high inflation in the United States, the dollar value may be lower against other currencies. Therefore, it is essential to have some home bias in your local currency to protect against these temporary events.
It is important to note that inflation (and interest rates) is only one factor that plays a role in currency exchange rates. So, just because inflation is high does not mean that currency exchange rates will move in one direction or another.
It is also important to note that if inflation is global like it seems to be the case currently because of supply chains issues and COVID, the effect on currency exchange rates will likely be limited. In general, local inflation events will have a more significant impact on currency exchange rates.
What can we do?
Now, what can we do about inflation?
As seen in the previous sections, there are a few things we can do:
- Invest in assets that perform well in times of high inflation, like stocks and REITs
- Invest in assets with good average and median real returns, like stocks
- Use debt wisely
- Avoid assets with fixed payments
- Avoid too large exposure to a currency with high inflation
These moves will help reduce the effects of inflation on your investments. But they will not eliminate these effects. We have to live with price increases. And if inflation is global, like it seems to be the case currently, every country will be exposed.
Conclusion – What should we do?
In summary, we should not do anything in reaction to high inflation. When high increases in prices are announced by statistics offices worldwide, it is probably too late already to do anything. I will not change anything on my portfolio because of the return of high inflation.
What is important is to be prepared for inflation. Ideally, your portfolio should contain assets with high real returns. That way, regardless of the situation, you will have good returns, on average.
And as always, you should take your risk capacity into account in your asset allocation. With a reasonable asset allocation, you can withstand most situations without trouble.
If you are not yet investing and are worried about your purchasing power, it may be a good time to start investing in stocks.
I will personally not change anything in my strategy because of price spikes. And you?