In Income Investing we discussed how to tweak the basic model ETF portfolio to emphasize income with minimal effect on its broad return and risk characteristics. Here we’ll take a look at how an investor that is particularly concerned about inflation or deflation might adapt it to address those concerns.
Why might you do this? It’s all about your total financial picture. Suppose for example you have a pension or annuity that you believe is very solid but that you expect either will not adjust for inflation or will inadequately adjust. You believe the main risk to your long term financial health in retirement is inflation. Your income could decline in real terms as the value of the dollars you receive declines. So you decide to configure your investment portfolio to try and hedge this risk. You accept that if inflation turns out to be low or that even deflation dominates your retirement years that your portfolio will underperform, but in that case you expect your pension will have you covered.
Let’s take another look at the basic model portfolio. Half of it is in dollar denominated investments – US Treasury securities – whose value will rise and fall with the value of the dollar. Half is in non-dollar-denominated investments whose value is independent of the value of the dollar. You could say it is balanced in that half of it will outperform in a low inflation or deflationary scenario and half is likely to outperform in an inflationary environment.
Short Term Treasuries 10%
Medium & Long Term Treasuries 40%
So we’re already half way there. To emphasize inflation hedging in the model you can decrease the Treasury allocations and increase the equity and commodity allocations.
Short Term Treasuries 7.5%
Medium & Long Term Treasuries 30%
Suppose on the other hand you have no pension or other dollar denominated assets but own a home and expect to inherit a business with inflation responsive pricing power, say a coal or copper mine. You realize your retirement involves substantial dollar denominated expenses or obligations and that the chief risk to your long term financial well being would be deflation. In such a case you might go the other direction and increase your bond allocations and decrease your equity and commodity allocations.
Short Term Treasuries 12.5%
Medium & Long Term Treasuries 50%
If you have a clear way of accounting for the effect of these circumstances, instead of changing the target allocations, alternatively you can incorporate their effect into your effective exposure. For example, you estimate an equivalent bond position from your pension or annuity and treat it as a portfolio allocation to bonds.