Direction of Inflation vs. Absolute Rate of Inflation
For investing purposes the direction of inflation is more important than the absolute rate of inflation. Studies of historical data show that investments react much differently when inflation is accelerating than during periods of disinflation (rate of inflation is decreasing). In following posts we will examine an asset allocation guide for other inflation scenarios:
Investing In Times of Increasing Inflation
Increasing inflation can be caused by increases in the supply of money, increased access to credit, or demand that outstrips supply. In reality, inflation is usually caused by all or a combination of these factors.
One of the keys to successful investing is to recognize where the inflation cycle is in the national and global economy. If an investor recognizes an accelerating inflation trend, and believes it will continue, they should consider the following investing guide for their portfolio asset allocation. (Always check with your financial advisor to be sure an investment is right for your individual situation.)
Increasing Inflation Guide
Large-Cap Stocks – Over weight stocks that earn a large portion of their earnings overseas and will benefit by a falling dollar. Underweight quality dividend paying stocks.
Small-Cap Stocks – Historically small companies are more nimble and do well when prices are accelerating. Overweight small growth companies. Underweight small value companies.
Foreign Stocks- International diversification and can provide a bonus from a weak dollar. Overweight emerging markets and high growth foreign stocks.
Corporate Bonds- Bonds as a category should be under weighted or avoided. As interest rates rise bond prices fall. Within the bond category high quality bonds should be under weighted; high-yield bonds over weighted.
Treasury and other High Quality Bonds- Avoid
Treasury Bills- have one of the highest correlations to inflation of any investment. The upside can be increasing rates and safety not provided in bonds as interest rates rise. The downside is generally low returns.
Inflation Indexed Bonds – In theory, Treasury Inflation Protected Securities (TIPS), and other inflation indexed bonds, should be over weighted because they have a high correlation with inflation. However the nominal yield is very important. Yes they are providing protection against inflation, but be sure you understand when to buy TIPS because sometimes the nominal yield is negative, making them not as attractive.
Commodities- Over weight commodities because they have the highest correlation to inflation of any investment. This is the best time of the inflation cycle to own commodities.
Gold & Silver - The best time of the inflation cycle to own Gold & Silver is when inflation is accelerating. Gold and Silver can provide spectacular returns during these periods.
Real Estate – The best time to own real estate is when inflation is accelerating. But Real Estate has some unique problems too. Many people use leverage to buy real estate. Rising interest rates can hurt investors with variable rate mortgages and put downward pressure on real estate prices.
Summary
This provides a good starting point for further research. Asset allocation is the single biggest determinant of your investment returns. Keep in mind that investments you avoid can be just as important as the investments chosen to take positions in. Use your asset allocation to adapt to the proper inflation cycle and your chances of success will greatly improve. Investing when inflation is on the rise requires an asset allocation guide that factors in rising interest rates but takes advantage of the factors causing inflation.
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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