Throughout history two of the biggest long-term risks to investors have been inflation and deflation. Unlike the risks we examined in prior posts—personal goals, lifestyle considerations, planning assumptions, market volatility—investors have little control over their occurrence and limited tools to manage their risk.
Prolonged hyper-inflation is perhaps the most likely “long-term” risk to modern-day American investors. Such an event could severely erode the purchasing power of your savings for decades, possibly creating a big enough loss that recovery would not be possible within your lifetime. Over the past century, this very scenario has happened in many developed nations.
On the other side of the coin, severe and prolonged deflation may not seem like such a bad thing at first glance, since it would increase the real value of money. However, deflation is typically associated with unemployment and a struggling economy, which can further lead to significant geopolitical turmoil.
Prior to the 20th century, most of the world relied on hard-money, that is currency backed by silver and gold. During these times, a common cause of inflation and deflation was simply the changes in the supply of these precious metals. After the World War I and the Great Depression, nations abandoned the gold standard, established central banks, and issued fiat currency (not backed by silver and gold). With these changes, deflation has mostly disappeared, since central banks now have the ability to print money in order to drive up prices and combat deflationary pressures. As a result of the same ability, the risk of inflation has perhaps increased.
While stocks in the local market may suffer, at least initially from either inflation or deflation, a globally diversified stock portfolio actually provides some of the best long-term protection to both scenarios. In the more likely inflationary scenario, a portfolio that is tilted toward value stocks would be expected to perform even better as these companies tend to be more leveraged and benefit from the real value of their fixed-rate liabilities declining.
Bonds, particularly those with long durations, tend to get decimated by unexpected inflation. Conversely, long-term bonds perform quite well during deflationary environments. Given the belief that inflation is the more likely risk, the deflationary benefits of long-term bonds do not outweigh their inflationary risk. Most investors would be well-served to maintain a short to intermediate duration in their bond portfolio. An attractive alternative to longer-term nominal bonds is Treasury Inflation-Protected Securities (TIPS). TIPS are bonds issued by the US Treasury and backed by the full faith and credit of the US Government but pay a fixed real interest rate plus an adjustment for actual inflation. They allow investors to avoid the short-term volatility risks of stocks without assuming the purchasing power risk that comes with nominal bonds. Those in or approaching retirement should probably consider having a healthy allocation to TIPS.
Gold, often thought to be a natural inflation hedge, doesn’t actually perform that spectacularly during periods of prolonged inflation, and in fact does better during periods of deflation. When inflation is high, it appears that gold is just another commodity to measure inflation against so there’s little reason to assume it would perform better than other metals, grain, or oil. Conversely, when the public loses faith in the financial system, which is often associated with deflation, panic ensues and people flock to tangible gold bullion.
The takeaways for investors are relatively straight-forward. In the long-run a globally diversified stock portfolio, which represents ownership of thousands of companies around the world is one of the best hedges against macroeconomic events such as inflation and deflation. Still, most investors do not have time horizons long enough or risk tolerances high enough to be fully invested in stocks and therefore should invest a reasonable portion of their portfolio in bonds. As the proportion of bonds to stocks increase, the portfolio becomes more susceptible to unexpected inflation and this risk should be hedged by allocating at least the longer portion of the bond portfolio to TIPS. In all but a deflationary environment, gold is probably not going to be a productive investment in the long run. If deflation or geopolitical instability is of particular concern, then owning gold bullion may provide some protection, but it’s best to think of it as insurance rather than an investment.