Interest Rates, Inflation, and Investment Strategy Part 3: Investing in Uncertain Times
After taking a closer look at interest rates in part 1 and inflation in part 2, we come to the heart of the matter: When interest rates, inflation, or both are on the rise, what’s an investor to do?
Big picture, we are continuing to deploy the same core principles we use to help people invest across time and through various market conditions. These include:
- Building and maintaining personalized investment portfolios of stocks, bonds, select alternative investments, and cash reserves
- Minimizing exposure to concentrated investment risks through global diversification
- Reducing the impulse to act on fear, excitement, and similar reactions to unfolding news
- Keeping an eye on tax ramifications and other costs
If anything, adhering to these timeless tenets becomes even more important during increased geopolitical uncertainty and economic stress—to guide you past any bouts of doubt.
With so much going on, there’s been no lack of analyses of what to expect across various markets, and what investment actions you should take based on these forecasts.
The trouble is, it’s as devilishly difficult as ever to predict the future. For example, your psychic talents are far better than ours if you can predict exactly how Putin’s war is going to play out, let alone how its effects will converge with myriad others to drive future market pricing.
Moreover, those best positioned to offer the most informed insights about the future may be the voices you’re least likely to hear. Wharton Professor Phil Tetlock has dedicated much of his career to studying the efficacy of expert forecasters, and his research suggests as follows:
“People who generate better sound bites generate better media ratings, and that is what gets people promoted in the media business. So there is a bit of a perverse inverse relationship between having the skills that go into being a good forecaster and having the skills that go into being an effective media presence.”
If we look to the past, we can find ample evidence of just how hard it is to reliably anticipate various markets’ reactions to current events. Following are some relevant examples:
Global investing and inflation: In their 2021 analysis, “US Inflation and Global Asset Returns,” Wei Dai and Mamdouh Medhat of Dimensional Fund Advisors studied how bonds, stocks, industry portfolios, factor premiums, commodities, and REITs performed during periods of high and low U.S. inflation from 1927–2020. They found that “most assets had positive average real returns in both low- and high-inflation years.”
Bond investing and interest rates: In “All Eyes on the Fed?” Dimensional Fund Advisors also examined whether Federal target funds rate changes have influenced either global government bond returns, or longer- vs. shorter-duration bond returns. They concluded: “Our analysis of global government bond data from 1984–2021 shows no reliable relation between past changes in the federal funds rate and either future bond excess return over cash or future term premiums.”
Bond investing and interest rates (again): You may recall, interest rates did tick upward in 2017–2018, creating concerns similar to those we’re hearing today. At the time, financial author Larry Swedroe published an ETF.com piece, “Rising Rates Increase Worries,” in which he illustrated why it’s best to disregard breaking news about rising rates (emphasis ours):
“As in 2018, we entered 2017 with the market anticipating several increases in the federal funds rate. … Despite that, the Vanguard Long-Term Treasury Index ETF (VGLT) returned 8.6% in 2017, outperforming the Vanguard Intermediate-Term Treasury Index ETF (VGIT), which returned 1.7% and the Vanguard Short-Term Treasury Index ETF (VGSH), which returned 0.0%. Investors scared off by the likelihood of rising rates suffered for betting against the collective wisdom of the market.”
Factor investing and economic cycles: One of our timeless investment strategies is to allocate our portfolios across various market “factors,” or sources of expected return, in pursuit of particular long-term outcomes. In an Alpha Architect guest post, “Factor Investing Premiums and the Economic Cycle,” Swedroe also examined whether it had made good historical sense to shift those allocations in response to economic cycles. Bottom line, it had not. Compiling the findings from a number of academic studies, he concludes: “Although a factor’s return changes throughout the business cycle, the ability to predict economic regimes and alter factor allocations accordingly produces less successful results despite being intuitively pleasing.”
Global investing and geopolitics: Even if we can’t peer into the future, we can already see for ourselves the horrific toll Putin’s war is wreaking. Shouldn’t that translate into predictable “winning” and “losing” investments? Once again, the practical answer is no. In his recent work, “Chaos is a friend of mine,” financial columnist Bob Seawright points to a range of historical events demonstrating why complex adaptive systems like financial markets are essentially unpredictable. That’s thanks in large part to chaos theory (aka, “the butterfly effect”):
“Financial markets exhibit the kinds of behaviors that might be predicted by chaos theory … [E]ven tiny differences in initial conditions or infinitesimal changes to current, seemingly stable conditions, can result in monumentally different outcomes.”
In other words, news from the front lines may seem tremendous or trivial, awful or inspiring, or even everything at once. But avoid letting any of it heavily influence your actionable investment insights; the world is just too chaotic for that.
Layers of Protection
By now, we hope we’ve described what NOT to do in response to current events: Across stock and bond assets alike, it remains as ill-advised as ever to chase or flee individual positions, markets, or economic cycles.
If your investment portfolio is already well-structured, you should already be well-positioned to capture appropriate measures of expected investment premiums over time, while defending against inflation and other risk/reward tradeoffs. It may not feel like it right now, while we’re enduring the rising risks. And unfortunately, even a best-laid plan doesn’t guarantee success. But if you weigh the odds, your best course by far is probably the one you’ve already got.
At the same time, it’s worth reviewing what you are seeking to achieve as an investor, by deploying two broad strategies for protecting against inflation:
Hedging against inflation: To preserve the spending power of upcoming cash flows out of your portfolio (such as in retirement), you can hedge some of your assets against rising inflation.
For example, you can allocate more of your fixed income to assets that tend to move in tandem with inflation, such as Treasury Inflation-Protected Securities (TIPS) versus “regular” Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across various inflationary rates.
We do not suggest piling into assets that may be periodically inflation-sensitive, but also exhibit heightened volatility—such as energy stocks, gold, and other commodities. Who needs a different sort of excess uncertainty as part of your hedging safety net? (The aforementioned report, “US Inflation and Global Asset Returns,” explores this point further.)
Outperforming inflation: At the same time, your longer-term financial goals typically require a portion of your portfolio to outperform inflation over the long haul. For that, you need to stay invested in various markets. As Dimensional’s Dai and Medhat concluded in a recent report, “Overall, outpacing inflation over the long term has been the rule rather than the exception among the assets we study.”
- Stocks: Equities in general, and especially stock factors such as the value premium, have handily outpaced inflation over time.
- Bonds: Investing in bonds that offer the highest yield for the least amount of term, credit, and call risk is also expected to help a portfolio stay ahead of inflation over time. (A timely tip: As in any other market, avoid trying to time the bond market in response to breaking news.)
- Alternative investments: As costs and complexities are coming down among certain alternative investment solutions, you may consider allocating a modest portion of your portfolio to alternative markets such as reinsurance or alternative lending; this may help lower your portfolio’s overall volatility without sacrificing expected returns.
Most investors require elements of both hedging and outperforming inflation, calling for portfolios that are constructed accordingly. Additional defenses against inflation can include: (1) using relatively realistic inflation estimates in your financial and retirement planning; and (2) delaying taking Social Security when possible, to maximize the power of the COLA (cost of living adjustments) on higher monthly payments.
United We Stand
This brings us to a wrap on our three-part series on inflation, interest rates, and your investments. We threw a lot at you in a short space, so please consider our report as more of a conversation-starter than a comprehensive guide. Most important, the decisions you make moving forward should be grounded in your own circumstances rather than general rules of thumb. For that, the best way to move forward is together. Please be in touch if we can assist.