Introduction: Why Inflation Matters Inflation is one of the most powerful — and misunderstood — forces in investing. It quietly erodes purchasing power, reshapes economic incentives, and redistributes wealth between…
Surely you have not missed the talks about inflation the past year. Even from the Fed and Yellen, the sentiment about inflation has changed from “not a problem” to “transitory” to “longer than first expected” and now to “good for the economy”.
While the price of risk assets, such as stocks, may also inflate due to the rise in inflation, they are not rising as much in real terms.
Rising inflation, and especially inflation that is higher than expected, is harmful to most common portfolios that comprise of stocks, or a combination of the two like the 60/40 Portfolio. Both stock and bonds are assets that perform well in times of low or decreasing inflation, and will lag in times when inflation rises.
It is thus vital to have a portfolio which also includes inflation hedges to mitigate the risk of unexpected inflation prints.
In this post, we will be looking at different types of inflation - as inflation can manifest in different ways - and how you can protect your wealth against each of them with different assets.
When it comes to the All Seasons Portfolio strategy, or any other risk parity strategy for that matter, one of the fundamental ingredients is how to allocate the capital between assets in the portfolio based on risk rather than capital.
Why this is important, or even why bother doing it at all, is a question I get quite often. I think therefore it is time to have a closer look at risk parity portfolio allocation principles. Here I mean the reason for why the allocation to the assets is based on their risk (volatility) rather than equal weight based on capital.
In this article, for a comprehensible description, we will be examining a simple two-asset portfolio to illustrate the importance of weighting assets based on risk rather than capital. For this example, I will be using a 60/40 Portfolio consisting of 60% stocks and 40% bonds, as this is popularly (and erroneously) considered as a “balanced portfolio”, and as this is a portfolio allocation strategy among both retail and institutional investors.
What I have observed from discussions with retail investors who are not yet aware of the benefits of risk parity, is that there is a great misunderstand of the goals of risk parity, and incorrect expectations of what such strategies should provide.
When explaining what risk parity is, being a strategy that pieces together risk premiums and returns from a wider array of asset classes, but where the timing of the earned positive returns from each asset are spread out in such a fashion that during all economic regimes, some of the assets will see negative returns, but the positive returns of other assets will offset losses and provide your portfolio with an overall profit.
This means that through proper diversification, on a portfolio level you cancel out much of the volatility inherit in each of the individual asset classes, so that you get a much smoother ride with lower portfolio volatility, but can still expect equity-like returns over time. You should expect rolling hills and valleys rather than mountains and canyons.
But as I have alluded to in recent posts, even though the All Seasons Portfolio strategy and other similar strategies (Golden Butterfly, etc. for example) are rationally the best fit for most investors, during times when the stock market outperforms, it becomes difficult to see your neighbor get richer on the stock market while your safe portfolio lags.
This kind of underperformance fatigue sets you up for a great risk if you abandon the safe strategy for a high-risk strategy when the market crash (the one that you were protected against) occurs.
Diversification is the fundamental feature of portfolio management and asset allocation, but is there more to it than just measuring correlation and calling it a day?
In this article, we look more closely into the concept of convex return relationships between assets, ensuring that diversifiers perform and thus protect against the drawdowns of other assets in the portfolio.
Convex diversification profiles play an important role in the All Seasons Portfolio for making drawdowns shallower and creating opportunities for earning rebalancing premiums.
In 2022, inflation made its presence clear and undeniable. While it can be argued whether we experienced an inflation "surprise", investors were reminded of the importance of inflation hedges in their portfolios as stocks and bonds suffered.
Gold is one such inflation hedge, but he narrative in financial media has bashed its capabilities of protecting against inflation in 2022, as the gold price ($) was barely flat for the year.
In today's article, we will be reviewing whether gold has lost its appeal as an inflation hedge, or if it rather needs to be viewed from a different angle.