Words like turning point and uncharted territory are easily overused in investing. No-one rings a bell at the top or bottom, and it’s always different this time, so usually they are no help. But it’s probably fair to say that 2022 is shaping up to present one of the more challenging periods investors will have had to contend with in their lifetime.
Of all the current challenges of the moment, I think inflation is the one that should trouble investors the most. That’s because it eats away, often unseen, at the very purpose of investing which is: maintaining and transferring spending power through time.
In the industry, when faced with inflation we jump to asking, and writing things like: “how to hedge your portfolio“, “three asset classes that do better in inflationary environments” (hello emerging markets, REITs and small caps), “do stocks hedge inflation” (spoiler: no) and “should I buy gold” (spoiler: no). we usually ask the wrong kind of question about inflation.
These questions all just miss the far bigger point. What the industry won’t tell you, or even really face up to is that inflation can undermine some of the absolute basic fundamentals of investing: things like low risk assets, balanced portfolios, and lifestying allocations through time.
First things first, what really matter in investing? Contrary to what most investment reports will tell you, it certainly isn’t performance relative to an index, it isn’t risk, and it isn’t even returns. At least not in the way they are usually presented.
What matters is real returns (that is, returns over and above the level of inflation). And (I can’t stress this enough) … NET real returns after deducting all costs and charges you pay. That’s because this tells you how effectively you are preserving, or growing the purchasing power of your assets over time.
At 2% average inflation, it takes 35 years for the real value of your money to get cut in half. But at 5% inflation this takes just 14 years (Ben Carlson writes).
In today’s environment the real yield, that is the risk free returns you get less inflation, are deeply negative. This might seem like just a geeky actuarial fact until you realise it underpins the returns you will get on almost every other asset from bonds to stocks. Once you’ve added the additional risk premium you’ll get from holding stocks, you will probably get to a real return level that is reasonably positive albeit lower that in the past (see chart below from the well-known Credit Suisse yearbook), but don’t forget to take off all fees and costs from that as well which the industry so often conveniently forgets to.
The first obvious issue here that is plain to see is that returns in the future are likely to be lower than in the past. The flip side of this is you will need to save more, save for longer or take more risk to get to the same outcome compared to in the past.
A relatively simple chart like the one below shows that for the same investment outcome as in the past, you’ll need a radically different portfolio today – 80% in growth assets compared to 15% a decade ago (especially after fees). But you don’t tend to see this angle presented very often (LCP article).
However this is the sort of awful news that no-one wants to share with their happy, fee-paying clients so instead you tend to get one of two reactions: some sort of handwaving and smoke-and-mirrors and “everything will be fine” (while perhaps just quietly changing your fund’s target to remove any reference to inflation lest 2022 smash a hole in your track record) or else a magic new asset class that will come along and save the day, or at least distract you by being shiny and new (hello private markets and infrastructure).
I’ve nothing against private markets and infrastructure, perfectly good asset classes (and there are much worse answers to the question of low returns), but a 5 or 10% allocation to anything isn’t going to meaingfully change your portfolio (unless it’s literally magic).
This is a real shame as it distracts from some otherwise very meaningful conversations that if had properly could actually stand a chance of helping people get to a better place. For example many young people perhaps could be coaxed into taking a little more risk, if it meant retiring a decade earlier. Looking at individual portfolios more broadly, it might also make the case for running a little more borrowing in your overall mix (eg through paying a mortgage off a little slower, if you have the option). But leverage and 100% equity portfolios are things that we reflexively run a mile from and I think that’s a shame. Instead we have lets invest 5% in infrastructure.
Let’s get down to some other difficult truths about investing in a time of high inflation.
In this inflation environment bonds are one asset class that are likely to really struggle to give investors good real returns – that’s backed up by the Credit Suisse dataset.
This breaks lots of common rules of thumb in investing particularly balanced funds and the so-called “life styling” of asset allocations (phasing stocks into bonds on the way into retirement) .
Balanced funds
It’s quite amazing how anchored the industry is to 60/40, without anyone even knowing where it came from. Some say it originated as far back as the 1920’s , others say the 1950s/60s . And yes, it still dominates industry thinking in the 2020s. So many funds are set up that way, and look it’s worked, and what’s more makes a great story: equity-like returns, with half the risk. What’s not to like?
So, lots of investors’ money is parked in balanced funds with loose CPI +3% targets that in practice amount to little more than a 60/40 stock bond split with 1% or more of active fees layered on top. That’s not a good setup in a high-inflation, rate-hiking period of low returns.
I don’t want to be “that guy” calling the “death” of 60/40 for the thousandth time, but it is looking kinda passe and its the “40” you need to worry about.
this from AQR who peg the future returns on 60/40 at just 1.9% per year ahead of inflation (for a US investor), before you’ve accounted for fees. You can see the real issue here is in the bond part, not the equity part.
Lifestyling
Most pension schemes will start shifting your asset allocation from stocks to bonds as you get towards retirement , but this can start happening as early as your 40’s.
This might be based on a form you ticked ten years ago , for example .
This is to reduce your exposure to stock market risks , but introduces another risk: that inflation will eat away at the value of your savings .
Ten years ago when inflation was low and everyone bought annuities this shift into bonds as retirement approached looked very sensible , but the world has changed, yet many of these processes remain on autopilot, and thinking has really not been revisited. Conventional industry wisdom supports de-risking so much that it becomes a knee-jerk reaction from much of the industry, and not enough thought has been given to the real tradeoff of market risk vs inflation risk. I’m not saying it’s an easy question or has a clear answer, but it’d be good to at least try and address it?
And these autopilot lifestyling strategies could be silently shifting savers into assets likely to perform worst in an inflationary environment, just as savers are starting to build up a healthy sized investment pot. The issue has been papered over for years as bond funds have continued to give good returns as yields squeezed even lower in the covid era, but stands to reason that could reverse at some point.
The issue is the industry (and I am principally thinking of the UK here) just isn’t set up to be agile enough to deliver properly for customers here. The multiple layerings of providers, platforms and funds take years of beaurocracy to put in place and in the main, what works best in the industry is broadly to create a fund and spend the next decade flogging (or “distributing”) it, embedding it into as many platforms and sticky structures as possible. In a seemingly endless chain of providers with something to sell, there are precious few people actually taking the view of the investor in all of it.
This doesn’t support honest re-evaluation of the whole system and realistic efforts to make up for what is lacking. So the funds and approaches most people are directed in can be a decade out of date, and designed for a different era. For example, right now many investors would do far better with a stock tracker fund plus the highest interest savings account available (about 1%) than they would with a traditionally styled balanced fund loaded with over a percent per annum of charges on the whole amount.
But the industry can’t really offer this. Instead you could easily get directed partly into a conventional government bond fund, all risk and no return, and still pay big charges on it. That’s just one example, there are many other sorts of funds that could exist, but often don’t, or haven’t made it onto the platforms that matter: global inflation linked bonds, global short dated credit.
Conclusion: while higher inflation has been called for so long we’re probably sick of hearing about it, it doesn’t change the fact that most of us have spent our entire working lives in a period of low and stable inflation (certainly true for me, and I’ve 20 years of experience) and it is actually quite hard to adapt to a higher inflation period. It’s times like this when the investment industry does need to step up for its investors, but the real questions don’t get asked.
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