Managing inflation risks is never an easy task. It has grown more complicated and challenging in an increasingly complex world with unpredictable markets. Consequently, portfolio construction and asset allocation approaches must adapt to these unfolding challenges.
This PDF, “Keepin’ It Real: Inflation risk as an asset allocation problem,” explores the challenges of managing inflation through a variety of environments. It takes a practical approach to inflation risk and proposes potential solutions for portfolio construction.
Inflation can be harmful to a portfolio in a variety of forms, including inflation that is high and rising, as well as low and falling. Independent factors, such as asset bubbles or changes in the business cycle, when added to inflation, can create very different outcomes and call for customized approaches.
With all that in mind, diversification is a critical first step for investors to take. Here are some other key takeaways:
- Inflation tends to move in cycles, with long stretches of moderate inflation followed by brief episodes of rising or falling inflation. Every asset has unique inflation-cycle sensitivities, and asset returns can be driven by independent factors, such as asset bubbles and bear markets.
- The most common scenario that poses an inflation risk is a period of low inflation combined with a bear market, resulting in negative real returns.
- In the long run, assets tend to have inflation expectations embedded in their expected returns, paying investors for taking inflation risk.
- Every inflation protection strategy carries some specific asset class risks. Accordingly, broad-ranging solutions work better than narrow solutions, which leave investors too exposed to risks. Diversified inflation-protection strategies can help manage risk, especially designed within the context of an investor’s total objective.
In general, diversification can help provide protection, from inflation risk as well as from other unknown risks. For that reason, inflation protection should be incorporated and treated as a core component of portfolio modeling and construction. Inflation strategies should be customized to address individual objectives and time horizons.