For many investors, having a fixed income component to the portfolio is a no brainer. However, there is still debate – and legitimately so – about how much of a portfolio should be fixed income versus equities. Most analysts believe the traditional “100-minus age” rule doesn’t really work well in today’s investment climate.
So, how does one structure a portfolio to manage investment return expectations in inflationary times?
The latest inflation numbers released by the Fed indicated a slight uptick in inflationary pressures. January’s reading saw core inflation annualized at 2.9%, with February’s numbers showing a 3.1% three-month annualized gain. And although there isn’t any cause for alarm just yet, investors and portfolio managers should look at the long-run when making portfolio-positioning decisions. Over the long-term, inflation:
- Increases the cost of everyday living
- Erodes buying power
- Makes investment returns less attractive
In a rising inflation environment, if you lock yourself into a longer-duration fixed income vehicle (Bonds or CDs), you could be eroding some of your portfolio value – without doing much! Consider this simplistic scenario:
- If you invested $100,000 at (let’s say) 10% ROR, you could earn $10,000 a year
- However, if inflation hovers around 3% annually, that $10k would actually be worth just $9,700 at the end of the first year
- In the second year, your $10k would have further eroded, netting you just $9,400 in real terms
If you are retired, or at the cusp of retiring, you can’t afford to have part of your portfolio’s returns declining each year.
So, is there a way that you might protect your portfolios from the impact of inflation? While you can’t build a moat around your investments that will protect it 100% from inflationary erosion, you can position it so as to minimize that impact.
Here are two strategies that you might wish to consider:
1) Be Short-sighted: When it comes to bonds and other fixed-income investments, consider investing for the short-term. For instance, rather than locking yourself for 10-years in a bond that’s yielding (let’s say) 5%, be just a little less ambitious and invest in something that may yield less (perhaps 3%) over a 2-year horizon.
How will this help your portfolio?
If there is runaway inflation and the return on the rest of your portfolio suffers, at least part of your portfolio will still yield you 3% for the duration. On the other hand, when the bond matures, you’ll now be able to use those funds for onward deployment.
If you see inflation continue to rise, you could redeploy those funds into other, slightly riskier, higher-yielding investments. Or, you may decide to re-invest in another round of shorter-duration fixed income vehicles. The point is: Your money won’t be locked into a low-yielding investment for too long.
2) Look for best-of-breed: While it is a good idea to hedge your bets by investing a bit of your portfolio in fixed-income investments, it’s a great strategy to invest in higher-yielding fixed-income proxies. For instance:
- Look for dividend-paying stocks that have never suspended a dividend payment over the last 25-years or more
- Find and invest in stocks that have a consistent track-record of growing their dividend payments
The best-of-breed stocks that fit both these criteria are found on the list of S&P 500 Dividend Aristocrats SPDAUDP), and include names like:
Wal-Mart (WMT) – this retail giant has raised its dividend annually for the last 43 years
V.F. Corporation (VFC) – the company has a 44-year track record of raising its dividend each year
Hormel (HRL) – since 1928 the company has consistently paid a dividend for 354 consecutive quarters
If you still wish to stick with bond-like investments, then perhaps you should look at owning Convertible Bonds, that offer some form of inflation protection due to the fact that they sometimes trade like stocks, and sometimes like bonds. Treasury Inflation Protected Securities (TIPS) and, to some extent, Variable-rate securities might also be worth considering.
The author does not own any of the stocks mentioned in the article