With the global financial markets focused on the issue of inflation, many investors are wondering what they can do to protect their portfolios and their purchasing power. I often get these two questions at the same time. The problem is, in today’s markets you can’t both fully protect your principal and protect your purchasing power. Thus, you must decide which goal is more important, stability or purchasing power, and then structure your portfolio appropriately.
Here is what I mean. Let’s say that your only goal is stability. If that’s the only goal, then in theory you should simply hold cash-like assets. Conversely, if your only goal is long-term purchasing power, then you should hold diversified stocks. Why? Because stocks have been the primary long-term inflation-fighting investment.
Here is an example. If you had $100 in 1970, you’d need about $700 today to buy the same goods and services you could have bought in 1970 with $100. Thus, to keep up with inflation, you’d need seven times what you started with.
In 1970, the price of the Dow Jones Industrial Average stood at about 750. Today, it’s about 34,000. If you had invested $100 in 1970, you’d have about 45 times your original investment, and that’s without the additional impact of dividends.
While stocks have demonstrated they are good long-term inflation-fighting investments, they unfortunately are not a great short-term hedge against inflation. Often, when inflation accelerates, stocks go down and can even enter bear markets. So, at first, they seem like a bad idea, but it’s over time where their value shows up.
The challenge for most of us is that we have competing financial goals for different time horizons. While we want to outpace inflation over the next 20 years, we also don’t like to see our portfolios decline next week. That’s where thinking about how to position your portfolio between these competing goals helps.
I work with many clients who are retired and living off their money. The goals for the typical retired investor offer a good example of this balancing. Generally, retired investors need money every month, so they have a desire for stability and control. But they also need money 10, 20 and even 30 years from now. With inflation, the amount they need in the future will only grow. So how do you balance this?
You can view this balancing act in terms of liabilities you have to satisfy. For instance, you have some liabilities you must satisfy next month, next year, and 30 years from now. If we add them all up, you have more total liabilities that you have to satisfy between years six and 30 than you do between today and five years from now. For example, let’s assume you need $50,000 a year every year through a 30-year retirement, assuming no inflation. In the next five years, that means you need $250,000. But for years six through 30, you need $1,250,000. If inflation runs 3%, you’d need about $2 million for years six through 30.
Thus, you need some stability for the liabilities you have to satisfy in the next five years, but you need purchasing power protection for the liabilities you have to pay for years six through 30. That means you should weight your portfolio toward stocks because of their long-term ability to outpace inflation. How much you allocate to stocks is open to debate and depends on your personal risk tolerance. But the point is not to get too focused on short-term stability at the expense of long-term purchasing power protection.
If you are younger and don’t have any liabilities you need to pay from your portfolio over the next five years, arguably you could have almost all your money in stocks for the long term. But consider that none of us knows exactly when we might need money and for what reason. So, it’s prudent to have some stable money in case life circumstances change. But you may not need much more than 10% to 15% if you are younger.
While the long term numbers on stocks vs. inflation are compelling, it’s helpful to separate the short- term and long-term liabilities you have. Then hold assets that are likely to help you meet those different liabilities. It’s also important to understand the concept of short term vs. long term when discussing volatility in stock markets. Short term doesn’t mean one month. It can stretch out for years and you need to be prepared for that.
Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.
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