How To Build An Investment Portfolio For Inflationary Conditions…

The trend for the next decade is faster economic growth in emerging economies and higher inflation. In an attempt to profit rather than perish, it may behoove you to beef up holdings of real assets and lighten up on financial assets like most stocks and bonds.

This article focuses on inflation-resistant investment options, including some for income investors, who are otherwise vulnerable to losses during inflationary conditions.

We see these investments as viable during times of high inflation because they have one or more of the following three strengths:

• Their values are tied to the price of a real asset in some way or another
• They’ve historically been big-time beneficiaries of father economic growth
• They have the ability to outgrow inflation

These strengths will enable certain financial instruments to beat inflation in all but the most extreme economic conditions.

History never repeats itself exactly, but it does serve as our best guide to consider what happened the last time high inflation gripped the United States economy.

The proof is in the graph we have created below “Best of the ‘70s” which compares the performance of many sectors and asset classes, which include bank savings accounts, long-term bonds and overall stock market performance during the high inflation decade of the 1970s.

Much like recent, the ‘70s were characterized by relatively rapid economic growth; interrupted by a sharp slowdown early in the decade. Inflation ran into the double digits first following the Arab oil embargo of 1974 and again after the overthrow of the Shah of Iran in 1978.

Bonds finished the period under water by more than 4 percent a year vs. inflation, which was running at a blazing 8.1 percent. Excluding energy shares, the stock market lost more than 1 percent annually, as did cash.

In contrast, there were some investment sectors and asset classes that beat inflation by a wide margin.

During the 1970s, gold and silver’s 33/1 percent average annual gain beat inflation by 25 percentage points per year. Oil service company stocks beat inflation by 22.9 percent. Small stocks rolled up an average annual return of 17.5 percent, beating inflation by 9.4 percent.

There’s no way to predict the exact return any asset class will generate. With that said, equity REITs, for example, could theoretically be bigger winners than gold stocks. But if you diversify your portfolio with some picks from the best performing groups, you could be well positioned.

What To Do Now

How should you fit these inflation plays into your portfolio and how drastically should you act?

The answer depends in part on your own preferences and financial goals. In other words, conservative players should stick with safer inflation plays while more aggressive investors should focus on the higher-reward / risk choices.

Noteworthy Caveat: Long-term trends such as those we’ve described in this article take years to reach fruition. While commodity prices appear to have awakened from their decade-long slumber, investing in commodities today doesn’t guarantee overnight windfall gains. Prepare to be invested for the long haul.

The first building block of high inflation is:

High Economic Growth In Emerging Economies

The second building block of high inflation is:

Commodity and Resource Shortages / Scarcity

With these two building blocks of inflation already firmly in place, it’s only a matter of time before they trigger the third building block: the monetary / debt overhang’s money supply explosion.

The timing could take several months or several years, however, the outcome will be the same.

The key is to begin taking incremental action on your investment portfolio now. That way, you’ll avoid the need to make drastic changes that could cost you dearly in terms of brokerage commissions and tax liabilities, in addition to potential losses.

The first step is to start limiting your exposure to all those investments that generated real returns that were close to zero or negative; as shown on our graph of “The Best of the 1970s”.

Some other noteworthy historical data reveals that during the 1970s, money market returns didn’t keep up with inflation and aren’t likely to do so this time around either.

At the same time, you should begin adding the plays that performed better during the 1970s. One of the most important conclusions that can be derived from our graph is how easy it was to generate greater returns in the decade of the 1970s… Provided you were in the right investments.

Some Practical Advice…

Of course, all investors have the liberty to make their own investment decisions. We’re simply here to provide historical data and research in an effort to help investors take the best course of action regarding their individualized investment objectives.

Mutual fund investors might want to consider shifting their stock holdings from the traditional big company diversified funds to top quality choices specializing in small stocks. Those who are loaded up on, say, software companies for growth should perhaps consider diversifying some of their portfolio to include some holdings in commodities. Always an option…

Income investors might consider swapping some of their long-term bonds in favor of inflation-beating income generators like equity REITs and big oil stocks. Just an idea…

Investors whose primary concern is growth will want to concentrate on plays with more explosive growth potential; like perhaps the energy sector. Totally up to you…

On the flip side, those whose only goal is capital preservation can find safe haven in gold and other precious metals. Perhaps not for everyone…

Final Thoughts

Consequently, it will be some time before the three building blocks of inflation reach full force. But investors should make sure their portfolios are adjusting in the right direction. Specifically, most or all of your holdings should ultimately be able to beat inflation, whether they’re income or growth plays. And don’t wait too long to act.

As we’ve outlined, the trends of rising commodity prices, the mandate for faster economic growth globally in emerging economies and America’s huge monetary and debt overhang have a firm foundation. Slowly, perhaps imperceptibly to most, inflation is starting to infiltrate. Once this becomes unavoidably obvious to all, inflation-beating investment will no longer be bargains. The takeaway? It’s time to prepare now.

If you enjoyed this article and learned a little something from it… feel free to share it with a friend or fellow investor! Sharing is caring 🙂

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