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

This post is the fourth 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 any holding period, as short as 1 year or as long as 20, intermediate-term Treasuries are paradoxical. They offer better average returns but a greater risk of lost purchasing power, compared to short-term Treasuries.
  

In this post and another one to be published soon, I add some stocks to the mix, to see whether doing so might resolve the paradoxical properties of bond-only strategies and provide a sensible strategy for intermediate-term investing of 5 to 20 years.

Why Add Some Stocks?

The core question for today's post is whether a portfolio that contains a small allocation to stocks plus a good mix of bonds can meet two objectives:

1. The rate of return is at least as good as the historical rate for 10-year U.S. Treasuries. That's about 2.3% to 2.6% above the rate of inflation.
2. The risk of lost buying power is similar to 2-year U.S. Treasuries. It's consistently very, very low, even for holding periods as short as one year,

One reason to expect that stock investments would help a portfolio achieve these objectives is the experience of 2011-2014 in U.S. markets. During this period, inflation was very low, and short-term interest rates were even lower. Consequently, Treasury bonds and TIPS actually fell in value when adjusted for inflation, while stocks (and to a lesser extent, corporate bonds) rose. Another reason is that during a period of protracted inflation such as the 1940's, stock-prices might rise enough to compensate for losses in bonds.

As additional background on how a diversified portfolio can help investors manage the contradictory risks of inflation, deflation, and interest-rate polices, I recommend a recent article from Vanguard's chief economist and the manager of their TIPS funds. It's well worth reading.

Building a Portfolio

To cover a long historical record that included inflation, deflation, and economic growth, stagnation, and recession, I analyzed data for the period from January 1920 through June 2014. TIPS did not exist for most of this time, nor did I have adequate data on corporate bonds or non-U.S. investments for the entire period. The analysis was therefore limited to three classes of investments:

• U.S. large-company stocks, as represented by the S&P 500 with dividends reinvested (from Shiller).
• U.S. 10-year Treasury bonds, with interest reinvested (also from Shiller).
• U.S. 2-year Treasury bonds, as reported by the U.S. Treasury Department since 1976, and extrapolated backwards to 1920 by a statistical model that I developed which had virtually perfect accuracy (explaining 99% of the variance). The model regressed interest rates on 2-year treasuries against the interest rates of 10-year treasuries and 3-month T-bills.

For all three class of investments, I took two additional steps:

• The monthly rate of return was adjusted for that month's change in the Consumer Price Index.
• The portfolio was rebalanced quarterly, if and only if the average deviation from target allocations was 3% or more. This strategy was used because of findings I've previously reported for various rebalancing strategies. (See overall recommendations here and specifics for the quarterly strategy here.)

What Worked Best?

After looking at numerous combinations, I settled on the following as an excellent portfolio, within the constraints of the data available for the analysis:

• 10% U.S. stocks
• 20% 10-year Treasuries
• 70% 2-year Treasuries

A portfolio like this may be advantageous for investments that are possibly to be spent soon, such as an emergency or reserve fund, or a safety-net for unplanned health care costs, or the portion of a retirement portfolio set aside to cover living expenses for the next 1-5 years. In such cases, the goal is to achieve a modest return above inflation, if possible, while minimizing any risk of lost purchasing power. 

Below is a chart that shows historical results since 1920 for the 10-20-70 portfolio, and for portfolios invested entirely in 10-year or 2-year Treasuries.

The charts shows that the mixed portfolio, over the long term, had virtually the same compound rate of return as 10-year Treasuries, handily surpassing 2-year Treasuries and thereby satisfying objective #1. In addition, the chart suggests that the variation from year-to-year was lower for the mixed portfolio than for 10-year Treasuries, which would satisfy objective #2. This was particularly true from 1930 to 1950, when 10-year Treasuries rose strongly during the initial years of the Great Depression, then rapidly lost buying power because of the inflation that accompanied World War II.

For a closer look at objective #2, consider the next chart. It shows the percent of periods when a portfolio lost ground to inflation, for periods ranging in length from 1 year to 21 years. This chart confirms that for the mixed portfolio, the risk of lost buying power was always less than for 10-year Treasuries, and was nearly as low as 2-year Treasuries.

Furthermore, as the next chart shows, when losses did occur, they were very small for the mixed portfolio. In the rare occasions when losses occurred, the cumulative loss in buying power, over any holding period, was virtually zero for both 2-year Treasuries and the mixed portfolio. In contrast, for 10-year Treasuries, during the more frequent periods when losses occurred, the cumulative loss was, on average, about 1% to 3% in buying power.

Summing Up

Historically, for U.S. investments since 1920, a portfolio invested 10% in stocks, 20% in 10-year Treasuries, and 70% in 2-year Treasuries would have satisfied the twin objectives of having returns similar to intermediate bonds while providing robust protection against changes, up or down, in consumer prices. It may be a good portfolio for near-term objectives such as a reserve fund. However, the 10-20-70 mix would not be prudent for inflation-protection in long-term investments such as retirement plans or college savings more than 5-10 years in the future. That will be the subject of the next post in this series.

Note, too, that if one were to implement this portfolio with vehicles available today, it would make sense to have the stock portion invested in a fund that includes both U.S. and international stocks, and to have the 70% in short-term bonds diversified across Treasuries, TIPS, and corporate bonds. And the 10-20-70 percentages are not absolute. Modifying them by 5% or 10% would have generated similar results, historically. If your investment firms offers an all-in-one fund close to the 10-20-70 targets, and the fees are under 0.4%, I would personally find the all-in-one fund more attractive than having to manage a set of funds or ETFs exactly matching the targets.

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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 or security.