With the growing concerns around potential upcoming inflation, I’ve been wondering if our “money tree” should include additional protection against inflation.
I want to avoid decorating the tree with dead matter such as gold or commodities. They may shine for a while, in the long run they’ll just pull down the branches.
Equities in the long run should adjust to the inflation, therefore additional protection may not be necessary. However in the short run they tend to lose value, just as nominal bonds.
There are inflation-linked bonds, which protect against UNEXPECTED inflation. EXPECTED inflation is already build into the price of equity/nominal bonds. So when everyone starts to worry about inflation (like myself now), those concerns are already built into the current nominal bond pricing. Historically nominal bonds have acted as a good hedge against stock crashes, because money tends to fly to safety. Inflation-linked bonds are more volatile, so during a crash they don’t necessarily go up significantly. Therefore they are not a good hedge against stock crashes, contrary to nominal bonds. Also the inflation-linked bond market is not very liquid, so during market stress you don’t want to buy/sell.
Inflation-linked bonds will protect your money against unexpected inflation which can be valuable when you are in retirement and in need of funds in the short term.
There doesn’t appear to be concencus if inflation-linked bonds should be part of a portfolio. Most model portfolios do not include inflation-linked bonds. However, many advisors do seem to suggest some allocation. E.g. Bogle suggests ~6% of fixed income (whilst in retirement), Swedroe up to 80% of fixed income, Ferri 20% of fixed income.
The market cap of Eurozone inflation-linked bonds is about 8,5%. So adding inflation-linked bonds according to marketcap would be less than 3% assuming you have 30% fixed income. Therefore to keep things simple, I am not adding inflation-linked bonds for now.
There may be sufficient evidence to split e.g. 50% nominal and 50% inflation-linked, I still prefer additional protection during crashes than protection against unexpected inflation. That’s a personal choice.