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Inflation: Responding Appropriately with Flexibility and Discipline

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Inflation is a hot topic these days with many experts and financial institutions offering predictions about the short- and long-term outlook. The truth is, no one can tell the future, and trying to guess our way around what will or will not happen is poor financial planning. Instead, let us take an objective look at the risks associated with inflation, the right mentality for approaching the issue, and some ideas that can help investors still have a chance to achieve their financial goals.

Inflation represents real risk

In any discussion about inflation, it’s important to be honest about the implications it can have on the value of investment portfolios. The bottom line is this: inflation can inflict more damage on your portfolio than asset depreciation, taxes, or other expenses. It can truly act as a silent killer, eroding the value of investments, diminishing purchasing power, and compromising your long-term financial health.

This isn’t to say the sky is falling when inflation rises or to make inflation out to be some kind of boogeyman. Rather, it’s simply to point out the importance of accounting for inflation in your long-term financial plans. Recognizing its risk is the first step in developing a strategy that adequately accounts for it and provides the flexibility to adjust to changes over time.

Addressing inflation logically

Intellectually, investors know they need to hedge against a rise in costs and account for inflation by diversifying portfolios among various asset classes. However, because it does not show up as a line item on financial statements, it’s easy to lose track of inflation and forget about the direct impact it can have on your portfolio. Conversely, when inflation starts to rise, and various outlets start predicting the worst, it’s easy to let emotions influence decision-making and overreact based on opinions and limited short-term data.

In an inflationary environment, many investors believe interest rates will rise and the market will be too volatile for their individual risk tolerance. They want to convert assets to cash to guard against large market swings, believing cash holdings provide stability and security. Historically, this is exactly the opposite of what the data shows to be the best path forward.

Instead, you need to consider inflation as simply another risk factor and design your portfolio accordingly, prioritizing flexibility, tax efficiency, and diversification.

Designing portfolios to withstand inflation

The best strategy for dealing with inflation is to first identify the asset classes that are most likely to beat inflation. You then have to assess how you can add those assets to your portfolio while balancing out any new risk added in other areas — such as liquidity and market risk — and still meet your financial objectives.

There are several asset classes that can help to address inflation. Due to their short duration, T-Bills tend to track along with inflation quite well but rarely beat it. Equities tilted toward the Fama-French factors (size and price-to-book value) have been shown to outperform inflation in different environments.[1] This should be balanced against the added volatility and market risk that equity investments inherently carry. Finally, investors may also consider additional asset classes such as TIPS (Treasury Inflation-Protected Securities), although these do come with a higher interest rate risk.

Designing your portfolio to hedge against inflation is not as simple as just converting cash and maturing bonds to these other assets. You need to consider what kind of inflationary environment you are in and what is appropriate for the current situation. As inflation rates change, knowing what asset classes do well in different conditions is important. Overall, it’s critical to employ a dynamic allocation strategy (compared to a “buy and hold” strategy) that responds to evolving conditions and provides the flexibility you need to protect your long-term financial health.[2]

Sound planning trumps fortune telling

Trying to guess where the market is going and predict future inflation rates is a poor way to build a financial strategy. The more prudent path is to design your portfolio for flexibility, giving yourself the opportunity to adjust allocations as needed. As the risk posed by inflation fluctuates, the degree to which you react should be proportionate. Using a dynamic allocation strategy backed by attentive financial management can help investors withstand volatility, address inflation, and achieve long-term financial goals.

If you’d like to have a conversation about how best to address inflation in your portfolio design, Granite Harbor Advisors is happy to help.

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[1] Crawford, Liew, & Marks “Investing Under Inflation Risk” The Journal of Portfolio Management Vol. 39 Issue 3 2013 Pages 123-135

[2] Crawford, Liew, & Marks “Investing Under Inflation Risk” The Journal of Portfolio Management Vol. 39 Issue 3 2013 Pages 123-135

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