Market analysts are concerned about rate hikes by central banks as the global economy gradually recovers from the pandemic. How does inflation affect investors’ long-term investment strategy, and what is the best way to protect your savings from inflation?
0:00 - Introduction
8:48 - Introducing Dimensional
17:16 - US interest rates and treasury yields
21:30 - Coping with inflation
29:25 - Unexpected inflation
41:40 - How should we outpace inflation?
57:50 - Q&A
Excerpts from the webinar
US interest rates and treasury yields (17:16)
Wei Dai: The Fed does not have complete control over the entire treasury yield. Looking at the graph, you can see that the interest rate, no matter the duration, does not move in lockstep with the Fed’s fund raise. There are periods when the Fed raises fund rates, but certain parts of the yield curve are falling instead.
The yield curve, beyond the Fed target rates, is influenced by the demand and supply of many market participants, and they reflect the aggregate expectations of the future, including the potential actions of the Fed. Thus ultimately, the Fed does not have complete control over the entire yield curve.
Coping with inflation (21:30)
Wei Dai: It is reasonable to be worried about inflation, since it has a negative impact on the purchasing power of your invested wealth. To mitigate inflation, there are two approaches. One is to try to outpace inflation and preserve your purchasing power over the long run, by looking for assets with high real returns.
Second is to invest in growth assets that have higher expected returns, such as equities. This might not be suitable for all investors, as some investors may be very sensitive to inflation. They might prefer investing in assets that move very closely with inflation, so that the uncertainty around their real returns is reduced. This is also known as hedging inflation.
The good news is that most asset classes have average real returns in excess of inflation in years with above median inflation (i.e., years where inflation is above 2.68%). By staying invested in most asset classes and having a good asset allocation between equities and fixed income, most investors can outpace inflation over the long run fairly well.
Unexpected inflation (29:25)
Wei Dai: When it comes to hedging inflation, it is important to hedge the unexpected part of inflation, since realised inflation is the combination of expected inflation and unexpected inflation. Expected inflation is already embedded in the nominal assets that investors invest in. To see whether an asset class is a good inflation hedge, you want to observe if the asset class moves closely with inflation in the same period, and with the unexpected part of inflation.
Majority of these asset classes do not move reliably positive with unexpected inflation. Energy stocks and commodities are the asset classes with reliable coefficients in front of unexpected inflation. But if you look at their overall volatility, they are 20 times as high as the volatility of inflation. Therefore, if you use these asset classes to hedge inflation, you may end up with more volatility on your real returns, which defeats the purpose of reducing that uncertainty to begin with.
Greg: Some investors try to time the market and time different asset classes when they think that inflation is imminent. But given how volatile the market can get, it is very hard to successfully time the market. These speculations should be removed from your core investing — it is not worth risking your core portfolios with these extreme movements in specific asset classes.
Sean: If the intention of investors is to hedge against inflation and preserve their purchasing power for the long term, it would be questionable to include asset classes with huge volatility. Including these asset classes might potentially even be more hurtful than helpful in hedging inflation.
How should we outpace inflation? (41:40)
Wei Dai: There are some fundamental investing principles that investors should stick to regardless of market environment. Firstly, you should be aware of your risk tolerance and your expected return target. Secondly, the most effective tool to customise your desired risk-return trade off is to split your portfolio between equities and fixed income.
Equity heavier portfolios have higher expected returns and have more potential for outpacing inflation in the long run, but also come with more volatility.
After thinking about the broad split between equity and fixed income, you can consider the finer split within each asset class. There are three things to consider during this split. First is diversification. There are currently thousands of stocks across different markets, regions, and sectors. By diversifying, you can reduce any country-, sector-, or stock-specific risk. Second is dimensions. The global market is a good starting point, but you do not have to settle for market-like returns. There are segments of the market that offer higher expected returns, and you can position your portfolio accordingly in order to outperform the market without having to outguess the market. Third is discipline. Once you have decided on your asset allocation and investment approach, you need the discipline to stick to it in order to achieve your expected returns.
Greg: We are unable to predict what inflation will be in the short nor long term. You can invest with confidence once you decide on your risk tolerance and investment duration. If you want to take bets on the inflation rate in the short or long term, they can be considered speculations beyond the realm of personal finance investing, beyond your core family wealth.
There is also a risk of not investing, which is not keeping up with inflation and having your purchasing power decrease over time. This is an issue everyone has to face. Since we are living longer lives and we want to maintain the quality of life we have worked hard to achieve, we should be sure to stay invested to preserve our purchasing power.
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