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Investing and Fighting Inflation Thumbnail

Investing and Fighting Inflation

Posted by John Posey

Fact: The annual inflation rate for the United States is 8.3% for the 12 months ended April 2022.

I have a simple question for you. Would you prefer to accept volatility in investment values for the opportunity to experience a positive investment result after factoring in inflation OR would you prefer zero volatility in values with a near certainty of a negative investment result after factoring in inflation? I know what you’re saying, “Neither! Isn’t there an option #3? I want a sure thing that beats inflation with no downside tradeoffs…” Don’t we all but there is always a tradeoff. The tradeoff is accepting more market risk for the opportunity to better hedge inflation and grow values over time OR accepting more inflation risk to better preserve short-term values. The right answer for our personal investment portfolios is on a spectrum of risk and return we can personally live with based on our own circumstances. How you weigh these tradeoffs will have a material impact on your results and it’s valuable to make sure you have fully considered them.  Investing requires making some risk tradeoffs and the better you understand and recognize those tradeoffs the better the investor you will be.

You may recall this Seth Godin quote from the Risk Tradeoffs article,

“We can always make a risk ever smaller. But the cost is that we will increase other risks. Please don’t avoid appropriate caution…”

This perspective is as important today as ever while entering a new era of higher inflation and higher interest rates that we haven’t seen in years. Bond owners and traditionally conservative investors could be in for a rude awakening as higher interest rates are likely to bring more volatility to bond values particularly in the short run as rates increase. The steady-eddy bond performers of the past may have the ability at times to produce nauseating equity-like price fluctuations into the future.  The pace at which interest rates change will have a notable impact on fixed income values.

Author and advisor, Ben Carlson, highlighted an interesting inflationary time in history from 1966 to 1982 in this 2014 article. The historical circumstances do not exactly match today’s environment, yet it already seems to rhyme with today’s inflationary challenges.

My personal experience suggests many investors that lean more conservative often do not fully consider the risk of inflation and even less so during periods of heightened uncertainty. For many, as volatility ramps up corresponding appetites for market risk suddenly tank, however, it often was all good and well while values appreciated – this is purely human nature. A failure to recognize and understand risk tradeoffs can lead to some really poor behavior and outcomes, such as liquidating growth investments upon market declines. This is one the quickest ways to go broke I know of.  The volatility in investment values can slap many in the face on a monthly or quarterly statement basis yet the adverse effects of inflation don’t show up as a negative line item on your investment or bank statements so it’s unlikely to be recognized as often, if considered at all. Ignorance is not bliss for the long-term investor hunkering down in cash and guaranteed investment products lacking the realization or understanding of their chosen risk tradeoff.

Some investors have asked me, “If bonds are poised to struggle at large, why use them at all?” or “Why don’t we just use bonds that are protected against the risk of higher rates?” Those are fair questions. It seems most see the same train coming down the tracks in terms of higher inflation and interest rates (and many thought they saw it coming way before the year 2022) yet it’s often the train you don’t see coming that hits you. Simply put, I don’t think it would be a disciplined investment decision to completely abandon an asset class like bonds or to only use one particular category of investment (ie – short duration bonds) in light of a market expectation or forecast - that’s dangerous. That has the beginnings of a feast and famine investment experience written all over it. Changes in investment strategy in response to market forecasts or current events rather than changes in your personal financial life are most often a mistake. The reality is that we never know where things exactly go from here, so staying diversified is of great value. On the contrary, over and underweighting (rather than removing) asset classes and categories of investments according to your own preferences and goals is a wise consideration.

I like to think of investing as sailing a ship: the investment options are the sails and the market is like the wind. We of course cannot control the wind but we can certainly adjust the sails. In essence, I think successful investing is prudently and periodically adjusting the sails for the desired direction along the way. As things change we adjust the sails yet we rarely, if ever remove a sail because the wind is unpredictable – an idle sail may help us exactly when we need it as the winds inevitably shift.

When presented with the uncertainty and volatility of markets and the seemingly near certainty of negative real returns of cash and guaranteed products at the moment, I lean towards accepting a little more uncertainty and volatility where I can live with the risk for no other reason than at least I have a chance of a positive result net of inflation. Yes, I’m telling you there’s a chance, just as Llyod Christmas from Dumb & Dumber would say, but it should be markedly better than one in million. Equities offer a real opportunity to hedge inflation.

I think your chances are much better to experience good results if you stay disciplined to time-tested investment principles and a consistent strategy.

Don’t avoid appropriate caution.

Advisory services offered through Plains Advisory LLC, an investment adviser registered with the State of Nebraska. Insurance products and services are offered and sold separately through John Posey, a licensed insurance agent. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Any information provided is designed to provide general information on the subjects covered, it is not, however, intended to provide specific legal, tax, financial or investing advice and cannot be used to avoid tax penalties or to promote, market, or recommend any plan or arrangement. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness.  All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.