“Our research shows how inflation risk may differ based on one’s specific circumstances. It also provides a framework for determining an optimal asset allocation mix to hedge against one’s personalized inflation risk,” Vanguard’s Cheng Li, CFA, said.

Using hypothetical examples, Li; Victor Zhu, CFA; and Harshdeep Ahluwalia, the paper’s authors, show how one’s exposure to inflation can deviate dramatically from the CPI depending on social and economic factors, such as age, location, and income level.

“Although the CPI, which is based on a market basket of goods and services, is broadly representative of inflation in the U.S., an individual’s sensitivity to inflation, or Personalized Inflation Beta, can vary meaningfully depending on one’s circumstances,” Zhu said. “Because of the importance of one’s specific circumstances, a portfolio that hedges against inflation using only the CPI might over- or under-hedge the portfolio.”

For example, individuals under 25 tend to be more sensitive to inflation than what is reflected in the CPI, while those older than 75 tend to be less sensitive. This is partially because younger individuals generally spend more on transportation, which includes gasoline prices, historically a more volatile sector.

Using a proprietary modeling framework, the authors formulated a new, four-step process for understanding personalized CPI and hedging against it: Prepare, collect, process, and invest.

Prepare: Understanding where one spends money is an important step in managing sensitivity to inflation. It includes making a list of all expected expenses, such as rent or mortgage payments, car payments, utilities, groceries, and entertainment. The totals for each category are added up to get an estimate of one’s monthly or yearly expenses. This gives investors a sense of how much money they can expect to spend each month or year.

Collect: Our personalized inflation calculator produces an inflation rate based on one’s expected spending budget. The calculator also estimates personalized inflation beta and alpha—the necessary outputs for simulations that can be used to create personalized inflation-hedged portfolios.

Process: Using the Vanguard Capital Markets Model (VCMM),¹ we can create personalized inflation simulations. The process starts by incorporating the results from a personalized inflation calculator, then uses Monte Carlo methods to simulate inflation-adjusted projections.

Invest: By using the inflation-hedging capability of the Vanguard Asset Allocation Model (VAAM),² we can tailor an optimized portfolio to one’s specific circumstances.

“The four-step process is an important step in determining inflation risk based on specific circumstances and in developing an optimal asset allocation to address this risk,” Zhu said.

• Hedging your portfolio against inflation (article, issued January 2023)
• Constructing inflation-resilient portfolios (14-page PDF, issued January 2023)
• Understanding the drivers of inflation (video, issued January 2023)