I know many investors are concerned about inflation. It has risen to levels that many parts of the developed world haven’t seen for 40 years – exceeding 8% in the US last month alone.
In the US, the Federal Reserve is trying to break inflation by slowing the economy – increasing rates, reducing liquidity, and increasing the costs of borrowing.
Of course, monetary policy is a blunt instrument and there is a not an insignificant chance that the US economy dips into a recession in the next year.
Rising rates have caused the bond and stock market to reprice dramatically over the past few weeks. The increasing chance of a recession undermined equities further. As you’ve seen in your portfolio, when rates go up quickly, equity and bond prices tend to go down together.
Now, the news cycle is full of claims that 60/40 (traditional diversification) is dead. Hardly. It is time tested since the late 1920s. It has seen high inflation, low inflation, bull markets, and bear markets1. Market and business cycles of different shapes and sizes.
Here is what we know:
First, a diversified portfolio gives investors the best odds of increasing purchasing power over the longer term, even in a high-inflation world. Time and time again, equities have proven a strong diversifier.
Second, we’ve seen some investors tilt towards commodities, REITs and TIPS2. These types of hedges can help for unexpected jumps in inflation. But an investor must hold them ahead of time. And, over the long run, some hedges, like commodities, can raise volatility in your portfolio to intolerable levels.
Third, you’ll be glad to have bonds in your portfolio if we enter a recession.
And finally, remember rising rates aren’t all bad for bond investors. You’ll be reinvesting at an even higher yield.
As markets go down, avoid the trap of doing something. Locking in losses usually means missing the ensuing gains, too. Stay focused on your goals, maintain your disciplined approach, and enjoy the long-term benefits of a diversified portfolio.
1 Bear markets are defined as market declines of 20% or more from recent highs, while a bull market is a period of time when markets rise by 20% or more after such a decline.
2 Real estate investment trusts (REITs) are listed companies with tax advantages that own and often manage income-producing property. The exist in numerous countries including the UK. Treasury Inflation-Protected Securities (TIPS) are a type of US government bond indexed to inflation. re indexed to inflation in order to protect investors from a decline in the purchasing power of their money. Index-linked government bonds (gilts) are available in the UK.