January 31, 2023
While a traditional balanced portfolio of stocks and bonds has historically outpaced inflation over the long run, some investors may want to hedge against inflation more aggressively over the short to intermediate term. Our latest research suggests there’s a way to hedge an investor’s entire portfolio, but the method is not without risks.
“When hedging inflation, you have to think about the correlation with inflation versus the beta to inflation,” said Todd Schlanger, a Vanguard senior investment strategist and one of four authors of the paper Constructing Inflation-Resilient Portfolios. “It’s an important distinction. People tend to think of correlation, but that tends to be a poor gauge of an asset class’s ability to act as an inflation hedge.”
For example, in the chart below, short-term Treasury inflation-protected securities (TIPS) have the highest correlation to inflation among the asset classes in the study. When inflation goes up, there’s a correlation of 0.45 (out of 1.00) that short-term TIPS will move in the same direction. But correlation does not equate to the magnitude of the movement.
Short-term TIPS have an inflation beta of 0.85—meaning that when inflation goes up by 1%, the asset class’s value tends to go up by 0.85%. In other words, as an asset class, short-term TIPS hedges itself well, but it doesn’t do the same for an investor’s broader portfolio.
Source: Adapted from Vanguard paper Constructing Inflation-Resilient Portfolios. See the paper for more details on the asset classes and methodology used.
On the other hand, while commodities on average have a lower correlation of 0.34, they have a much higher inflation beta of 7.60. That means when inflation moves by 1%, commodity prices tend to move on average 7.6%. Thus, commodities as an asset class can help offset inflation for the entire portfolio, not just for itself.
But how much do you need to allocate to commodities to do this?
A traditional balanced portfolio of 60% stocks and 40% bonds has historically outpaced inflation over the long term, but it has a low beta to inflation (0.07) over the short term. If an investor wants a similar portfolio with an inflation beta of 1.00 for the entire portfolio, one way of achieving this would be to include an allocation of 12% commodities, along with a smaller allocation of 2% to TIPS (1% to short-term TIPS and 1% to intermediate-term TIPS.)
Source: Adapted from Vanguard paper Constructing Inflation-Resilient Portfolios. See the paper for more details.
But, Schlanger pointed out, there is one important caveat: Adding commodities may result in greater volatility and potentially long periods of underperformance.
“In fact, for much of the past 20 years, commodities had negative returns, which would have been a drag on any portfolio’s performance,” he added. “Yes, commodities can help hedge inflation over the short term—but you have to be prepared to accept the volatility. As with anything, there is no free lunch.”
For those who want to add inflation-hedging properties to their portfolios, adding commodities and TIPS is a viable option. For those who don’t prioritize short-term inflation-hedging, a traditional balanced portfolio can still work well.
For more details, including inflation-hedging asset mix alternatives that go beyond the 60/40 portfolio, see the paper.
All investing is subject to risk, including the possible loss of the money you invest.
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.
Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in derivatives may involve risks different from, and possibly greater than, those of investments in the underlying securities or assets.
Although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa.