Inflation is currently very low in many countries, so it’s easy to be complacent about it.
But inflation is always a potential threat and can make a drastic difference to investors’ outcomes. Its ‘real’, ie after-inflation, returns that matter to investors. Real returns are particularly important for retirees, as they don’t have a rising income to provide protection against inflation and must rely on their investments’ performance.
So what long-term diversified investment strategies can combat inflation?
Why we’re complacent, and what’s changed
Since the early 1980s, inflation rates in major economies have fallen dramatically and with them, the average levels of interest rates and bond yields. This provided a massive tailwind for share markets and returns.
But it’s a different world for an investor in a diversified fund starting their journey towards retirement today. After recent strong returns, share markets aren’t cheap. Globally, inflation is now low, as are interest rates in major developed countries. For very conservative investors, real returns (nominal deposit rates less current inflation) are negative, and likely to remain so for some time.
Bond yields remain close to historic lows in major bond markets. If current low inflation rates persist, an investor holding a 10 year government bond from today to maturity is likely to earn very modest real returns.
What if inflation rises?
With governments not using fiscal policy to boost economic growth, the burden of promoting growth has fallen on central banks. They’ve responded by keeping monetary policy extremely loose.
If higher inflation is the unspoken objective of this, or an unintended outcome, markets are largely unprepared. Even slightly higher inflation rates would wipe out any chance of a positive real return for investors buying government bonds today.
Traditional diversified funds can’t reliably deliver
Despite strong returns in recent years, mainstream assets like shares and traditional diversified investment strategies can’t guarantee solid real returns. There have been long historical periods when real returns from traditional asset classes and diversified funds have actually been negative – most recently, in the few years up to the end of 2012.
A diversified strategy is based on the idea that not every asset class delivers all the time. But there have also been periods when no traditional asset classes deliver anything like the kind of real returns investors need.
Actively managing asset allocation can help
There’s no way to guarantee a particular real return objective will be achieved.
But to maximise the chance of an adequate after-inflation return for investors, an investment manager needs to actively manage the asset allocation of their diversified portfolio with the aim of achieving a real return.
This means constantly assessing the potential risks and returns of each asset class as markets change. It means investing in assets when the risks are likely to be adequately rewarded by attractive real returns and holding back when they aren’t.
This is quite different to traditional diversified funds. They have a near static asset allocation between growth and defensive assets, so they largely reflect market performance – good or bad.
To aim for above-inflation returns, investment managers of diversified portfolios also need to look beyond mainstream assets to non-traditional assets and strategies. The more diversified the portfolio’s ‘building blocks’, the more potential sources of return.
This way, investors should be able to receive much better protection in the inevitable adverse market environments, but continue to enjoy the upside when markets perform well.
