If I’m worried inflation will increase, how do I protect my portfolio?

Protecting a portfolio from inflation is like buying insurance. By the time your house is on fire, it’s too late to get homeowner’s insurance. Likewise, by the time inflation has increased substantially, it may be too late to protect your portfolio from its effects.

Let’s look at the rise and fall of inflation over recent years and analyze which asset classes have performed the best during periods of higher inflation.

Asset Classes for Times of High Inflation

To beat inflation, your portfolio must achieve higher returns. In past periods of higher inflation, some asset classes have performed much better than others.

The chart below shows the average annual returns of several asset classes for periods when inflation was above average and periods when it was below average over the 25-year span from 1989 to 2013.

Front of Chart

Stocks and Commodities historically outperform bonds and cash in periods of high inflation

As the chart shows:

The inflation rate has averaged 2.7% annually for the last 25 years, but it has often varied around this long-term average. It’s been as low as 0.1% in 2008 and as high as 6.1% in 1990

Over that time period, stocks (with a return of 10.3%) have outperformed bonds (6.8%) and cash (3.7%). Commodities returned 5.2%.

Yet, when you look at the returns of these asset classes only in years with above average inflation, commodities significantly outperformed the other asset classes, returning an average of 17.9%. Stock returns were also strong, with an average of 11.0%.

Inflation and Federal Funds Rates

It’s not possible to predict inflation with certainty, but historically inflation has risen or remained flat following sharp declines in the federal funds rate.

The chart below shows the movement of the federal funds rate versus the inflation rate over the 25-year period from 1989 to 2013.

Back of Chart

Inflation Historically rises or remain flat following significant declines in the federal funds rate

As the chart shows:

The Federal Funds Rate is historically low following dramatic decreases.

Inflation has increased following two of the last three significant decreases in the Federal Funds Rate (including the current decrease).

In the third instance, inflation remained flat.

Investing involves risk, including possible loss of principal.

Diversification and asset allocation may not protect against market risk or loss of principal.

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