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How Does Inflation Impact Investment - Part B

4/30/2014

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In our last blog post, we showed how high and low inflation impact different investment assets' performances.

What does this mean to your investment portfolio?

The 60/40 Portfolio
The 60 stocks/40 bonds portfolio is common for many investors. We have seen the inflation-adjusted performance of the 60/40 portfolio was devastated during periods of high inflation - dropping to a median net return of 2.67% from a median gross return of 9.46%. 

During the more favorable periods of low inflation, the 60/40 portfolio showed a much smaller difference between gross and net performance, with an 11.86% gross return vs. a 9.37% net return.

Why the 60/40 portfolio is highly vulnerable to inflation? 


Because its 40% allocation to bonds, which suffer in periods of high inflation. The inflation-adjusted performance of the seven-asset portfolio shows more downside protection in times of high inflation, largely because of the inclusion of commodities: Its median gross return of 13.68% in high inflation periods fell to a more manageable 6.66% when adjusted for inflation.

The past 20-plus years have provided generally favorable conditions for a 60/40 portfolio. Interest rates have been in decline since 1982 — witness the 6.4% average annualized return for U.S. bonds since 1991 — and inflation has averaged 2.5% since 1991. Both of these factors provided a tailwind for bonds.

The Multi-asset Portfolio
Yet should inflation and interest rates both begin to rise, U.S. bonds will face a stiff headwind.
 The venerable, but underdiversified, 60/40 portfolio is not positioned to thrive during such conditions. 

It will be vitally important to build multi-asset portfolios that include diverse ingredients that are more resilient to the headwind of rising rates and inflation — such as commodities and real estate. 

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