On the Fed, Interest Rates, and Inflation (Part 3)

In recent columns we have explored interest rates, and inflation – now we come to the heart of the matter: When interest rates, inflation, or both are on the rise, what’s an investor to do?

Let’s start with the big picture. We remain committed to the same core principles we use to help people invest across time and through various market conditions. These include:

  • Building and maintaining personalized investment portfolios of stocks, bonds, and cash
  • Minimizing exposure to concentrated investment risks through global diversification
  • Low cost, tax efficient investments
  • Long-term focus

If anything, adhering to these timeless tenets becomes even more important during periods of increased economic stress, market volatility, and geopolitical uncertainty.

Future Uncertainty
With so much going on, there’s been no lack of analyses of what to expect across various markets, and what investment actions you should take based on these forecasts.

The trouble is, it’s as difficult as ever to predict the future. No one can accurately predict exactly how Putin’s war is going to play out or the future level of inflation – let alone how these factors will converge with myriad others to drive future market pricing.

Moreover, the media plays an outsized role in the content that is published, and it often targets human emotion. Investors who are tempted to act on these media messages should remember the media is selling entertainment, not real financial advice. “People who generate better sound bites generate better media ratings, and that is what gets people promoted in the media business” (Wharton Professor Phil Tetlock). News from the front lines may seem tremendous or trivial, awful or inspiring, or even everything at once. But avoid letting any of it heavily influence your investment portfolio; the world is just too complex for that.

Layers of Protection
Over the years, we hope we’ve communicated what NOT to do in response to current events: Across stock and bond assets alike, it remains as ill-advised as ever to chase or flee individual positions, markets, or economic cycles.

If your investment portfolio is already well-structured, you should be well-positioned to capture appropriate measures of expected investment performance over time, while defending against inflation and other risk/reward tradeoffs. It may not feel like it right now, while we’re enduring the rising risks. And unfortunately, even a best-laid plan doesn’t guarantee success. But if you weigh the odds, your best course by far is probably the one you’re already following.

Outperforming Inflation
In order to meet your longer-term financial goals, a portion of your portfolio will need to outperform inflation over the long haul. Dimensional Funds research team members Wei Dai, PhD and Mamdouh Medhat, PhD recently concluded that “simply staying invested helps outpace inflation over the long term for a wide range of asset classes.” The analysis covered 1927 to 2020, and considered a total of 23 US assets spanning bonds, stocks, industries, and equity premiums. Over this period, inflation averaged 5.5% per year in the study’s high-inflation years. While average real returns were mostly lower in years with high inflation compared to years with low inflation, all assets, except one-month T-bills had positive average real returns in high-inflation years. “Overall, outpacing inflation over the long term has been the rule rather than the exception among the assets in the study.”

  • Stocks: Equities in general, and especially stock factors such as the value premium, have handily outpaced inflation over time.
  • Bonds: Investing in bonds that offer the highest yield for the least amount of term, credit, and call risk is also expected to help a portfolio stay ahead of inflation over time.

Additional defenses against inflation can include: (1) using relatively realistic inflation estimates in your financial and retirement planning; and (2) delaying taking Social Security when possible, to maximize the power of the COLA (cost of living adjustments) on higher monthly payments.

United We Stand
This brings us to an end on our three-part series on inflation, interest rates, and your investments. We included a lot of information during that time, so please think of these columns as more of a conversation starter than a comprehensive guide. Most important, the decisions you make moving forward should be grounded in your own circumstances rather than general rules of thumb. For that, the best way to move forward is together. Please be in touch if we can assist.

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