Research summary

Assessing your personalized inflation risk

February 16, 2023

The Consumer Price Index (CPI), which measures the average change over time in the prices paid by consumers, is often used as a general benchmark for inflation. However, the CPI might not accurately measure a given individual’s sensitivity to inflation according to a new Vanguard research paper, Personalized Inflation Hedging: A Closer Look at Your True Consumer Price Index.

“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.

CPI challenges

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.

Understanding one’s personalized CPI: Prepare, collect, process, and invest

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.

1 The VCMM is a financial simulation engine that forecasts a non-normal return distribution of asset returns, volatilities, and cross-asset return correlations for passive assets and factors. The VCMM model can also incorporate current market conditions, such as level of interest rates, spreads, price-earnings ratios, and other fundamental drivers of asset return, to generate return expectations for the next 10 to 30 years.

2 The VAAM optimizes portfolios, mathematically configured to determine the best asset class trade-offs. It measures risk not in terms of volatility, as in traditional portfolio construction theory, but rather in terms of distribution of expected returns.

Notes:

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

This information is for general guidance only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions. We recommend that you consult a financial or tax advisor about your individual situation before investing.

CFA® is a registered trademark owned by CFA Institute.

Contributors