An Individual Investor's Guide to Managing Inflation Risk

The risk of high future inflation may be one of the most important risk factors individual investors will face in their investment lifetimes. In the United States, inflation measured by the Consumer Price Index has averaged approximately 3% per year since 1926. However, the inflation rate has varied greatly over time, ranging from deflationary (negative inflation) periods in the 1930s to double-digit inflation during parts of the 1970s.

The challenge facing individual investors is how to prudently protect themselves against unexpected inflation without overly exposing themselves to the many other risk factors they may face in building and protecting their wealth. This involves a process of balancing various risk factors that may affect a portfolio's expected return and uncertainty.

When thinking about inflation risk, it is important to acknowledge that current prices already reflect market participants' expectations of future inflation, given currently available information. For example, when inflation expectations are high we normally see high yields in fixed income markets, while the opposite and times of low inflationary expectations. It is new and unexpected information that causes changes in inflationary expectations, which quickly filters through market prices. This is what investors want to manage.

For long-term investors, it is important to hedge inflation by having a total investment return that outpaces inflation over longer periods. Many consider equities to be the most effective asset class in serving this purpose. Results vary depending on the time period and data series used, but historically, equities have generally outperformed inflation by several percentage points or more over the longer term. Therefore, investors with a long time horizon may be well served to hold a healthy percentage of their investments in a diversified portfolio of equities.

In the short run however, equities can deliver negative returns relative to inflation. Choosing to hold assets whose values tends to be highly correlated with inflation in the short run can help offset this risk. (Correlation refers to the co-movement of returns; assets that are highly correlated tend to move together.)

One of the more effective asset classes at hedging immediate inflation risk is short-term fixed income. Examples include money market funds, certificates of deposit, U.S. treasury bills and notes, and short-term, high-quality corporate debt. These types of assets have lower expected returns than equities, so there is a trade-off between immediate inflation protection and long-term growth potential.

Long-term bonds may not be good for hedging immediate inflation risk because of their high price volatility. Inflation can hurt long-term bondholders through falling market prices triggered by rising interest rates, as well as through the erosion of the real value of interest payments and principal at maturity. Additionally, certain asset classes such as gold or oil that are traditionally considered good inflation hedges may not be. Many commodities have much higher price volatility than inflation, which can reduce their hedging benefit, and their long-run expected returns may only be roughly equal to inflation (unlike stocks that have significantly higher expected returns than inflation).

The balance an investor chooses between equities and short-term fixed income depends upon a number of factors that are beyond the scope of this article. Part of the decision will be influenced by the degree to which one wants to hedge against the threat of near-term inflation at the cost of reduced long-term returns.

In general, younger investors may be attracted to portfolios with a higher percentage of equities, giving them potential for higher returns and greater protection against long-term inflation (but also greater volatility and uncertainty). Older investors often prefer larger percentages of fixed as their investment time horizon is shorter, risk tolerance is lower, and their need to hedge immediate inflation is greater.

Remember the following as you evaluate inflation risk:

* Assets that are highly correlated with inflation are better at hedging immediate inflation risk
* Expected inflation is already built into asset prices by market participants
* Hedging immediate inflation reduces long-term expected returns
* Inflation may be one of the most important risks you face
* Asset class diversification is important for any portfolio