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(in)(de)(no)flation: Mixing It Up, For Later

4/10/2015

 
This post is the fifth and last in a series about investing to protect against changes, up or down, in consumer prices. Previous posts argued that historically:
  • Stocks have offered the best protection against inflation over the very long term (18+ years), 
  • In the short term (0-5 years), investing exclusively in one type of bond fund may be ill-advised. Instead, a mix of short-term corporate and treasury bonds plus short-term TIPS may be prudent.
  • Over a holding periods from 1 to 20 years, intermediate-term Treasuries are paradoxical. They offer better average returns but a greater risk of lost purchasing power, compared to short-term Treasuries.
  • Adding a small allocation to stocks may create a portfolio well suited for 1-year to 5-year investments, having compound returns like intermediate-term bonds and price-protection like very short-term bonds.
In this post, I investigate how increasing your portfolio's allocation to stocks may generate sensible strategies for longer-term investing of 5 to 20 years.

Testing a Longer-Term Portfolio

The portfolios in this analysis are based on the data described in a previous post. There I considered a mix of 10% U.S. stocks, 20% intermediate-term Treasuries, and 70% short-term TIPs and bonds, which historically has had compound returns like intermediate-term Treasuries and price-protection like diversified short-term bonds. As an investment strategy, this mix looked attractive for short time-horizons, perhaps 1-5 years. As a point of comparison for longer periods, I flipped the percentages of stocks and short-term bonds, creating this portfolio:
  • 70% U.S. stocks
  • 20% 10-year Treasuries
  • 10% 2-year Treasuries
The chart below shows how, from 1920 to 2014, this portfolio compared to one invested entirely in stocks and to the portfolios reported earlier in this series. All the portfolios were rebalanced quarterly, if more than 3% out-of-balance, using methods explained here.
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If you had invested in 1920, totally ignored all the exciting and disturbing events that transpired for the next 94 years, and cashed out in mid-2014, putting all your money on stocks would have been the best strategy. If, on the other hand, you were not able to anesthetize yourself against churning markets and had less than 94 years of patience, would the portfolio with 70% in stocks have been better? In the chart above, the answer is not obvious. Yes, there was somewhat less churn, but it was still a bumpy ride.

Suppose, instead, that your time-horizon is 17 years. Perhaps you are investing a lump-sum toward the future college education of a newly born grandchild. Or you are investing this year's 401(k) contribution, with a plan to purchase a life-time fixed annuity when you retire 17 years from now. (As a retirement strategy, this may be a sensible plan in some limited cases, if your overall savings are low.)

If you had invested for 17 years starting in 1928, your results would have been as shown in the next chart, which has the same set of portfolios. This particular period had deflation in the early 1930's, inflation during the 1940's, and a severe economic downturn during the Great Depression. Voila! In this instance, the portfolio that had 70% invested in stocks was the best of the lot.
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Of course, this one example proves nothing. To see why, consider a second example, the 17-year period starting in 1966. Here a very sharp recession occurred, but no deflation. Instead, inflation was high and persistent. In this case, the bond-heavy portfolios all did better than the stock-heavy portfolios. However, the stock-portfolios kept pace with inflation overall, and a 70% allocation to stocks did a bit better than 100% in stocks.
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Examining Better Options

The flaws in the analysis above are twofold. We should ...
  • Consider all time periods, not just the two that started in 1928 and 1966.
  • Examine stock-allocations that increase from around 10% for short holding periods to 70% or more for long ones.
Using the same method of analysis reported earlier in this series, I examined all holding periods of 1, 3, 6, 9, 12, 15, 18, and 21 years duration, since 1920. I did so for the portfolios shown above, with a new twist. Instead of a portfolio always invested 70% in stocks, I created one that grew the stock-percentage as the holding-time lengthened:
  • For a 1-year period, only 10% went to stocks. 
  • For each additional year, the stock-percentage grew by 5%, until it reached 80% at 15 years.
  • After 15 years, the stock-percentage remained at 80%.
  • The allocation to short-term bonds decreased by the same amount that the stock-percentage grew. Thus it fell from 70% for a 1-year holding to 0% for 15 years.
  • The allocation to intermediate-term bonds remained at 20% throughout.
As shown in the next chart, this new portfolio rarely lost purchasing power. By this metric, the portfolio with a growing percentage of stocks did better than both 100% in stocks and 100% in intermediate Treasuries. It also did nearly as well as the portfolios that were stacked with short-term bonds.
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Furthermore, when losses did occur for the new portfolio (under 10% of the time in holding periods from 6 to 15 years long), the amount lost tended to be small. As the next chart shows, the losses amounted to about a half of one percent in purchasing power, on average.
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Importantly, the compound return of the portfolio with increasing stock-allocations was strong even after adjusting for inflation. The final chart shows how the inflation-adjusted return grew as the stock-allocation increased.
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Summing Up

Considering all the posts in this series, historical data implies that an investor can get price-protection (against losses to inflation and deflation) and also get good compound returns, by crafting a portfolio in which:
  • The allocation to stocks grows with the length of the holding period. This provides inflation-protection long-term.
  • A modest amount is allocated to intermediate Treasuries for all holding periods. This guards against deflation and recessions.
  • The remainder is allocated to a diversified mix of short-term TIPs and bonds. This assures some stability of returns, particularly for near-term spending.
  • The portfolio is rebalanced approximately quarterly, if it is more than 3% out of balance.
One might use slightly different percentages than illustrated above, and still get good results. Furthermore, with the funds and ETFs available now, it would make sense to invest the stock portion in both U.S. and international stocks, and to diversify the short-term portion across Treasuries, 0-5 year TIPS, and corporate bonds.

Historical data cannot guarantee future results. Although a mixture of bonds and stocks may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.

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    AC Wilkinson

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