Beating Inflation: How to Protect Your Long-Term Returns
History shows that inflation erodes long-term returns, but investors can diversify their portfolio to help protect wealth against rising costs. Here's how.
Inflation has been running hot for over five years now.
We know how this affects our grocery bills. We get an ugly reminder of that every week.
But how does it impact our long-term investment returns?
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Consider the S&P 500 since its inception in 1957. The index delivered compound annual returns, including dividends, of 10.6%. But stripping out the effects of inflation, that number drops to 6.8%, nearly 400 basis points lower than the number quoted in most marketing materials.
That might seem small, but it makes an enormous difference over time. One thousand dollars in 1957 compounded at 10.6% would be worth over $1 million today. That same $1,000 compounded at 6.8% would be worth about $94,000. That's a massive difference!
Winners and losers when inflation runs hot
Our accounts are measured in dollars. Inflation erodes the value of those dollars, which skews our perception of what our investments are worth. But not all assets are impacted equally. Let's take a look at how the broad asset classes performed during the last major period of sustained inflation, 1973 to 1981, when it averaged around 9.2% per year.
We'll start with what got hit the hardest. Long-term bonds were the decade's biggest casualty, losing nearly 40% of their value in real terms, even after coupon payments. When inflation is rising, bond yields have to rise to keep pace. And the way bond math works, rising yields mean lower prices. The longer the time to maturity, the more sensitive a bond is to yield changes.
What does this look like in today's market?
The iShares 20+ Year Treasury Bond ETF (TLT) reports an effective duration of about 15. In simple terms, this means that every 1% rise in interest rates results in an approximate 15% decline in TLT's share price. A 2% increase in rates can lower the value of the bond fund by around 30%.
Bonds are a mainstay in the portfolios of most retirees because they pay income and they're perceived as being less risky than stocks. But in a period of high inflation, bonds actually increase risk rather than mitigate it.
What about stocks?
Inflation hurts stocks too, and particularly growth stocks whose valuations are based on earnings estimates years or decades in the future.
Here's why. A dollar of earnings to be received five or 10 years from now is worth a lot less in today's dollars when inflation and interest rates are higher. So, the higher that interest rates go due to inflation, the less those future earnings are worth.
This isn't academic. We saw firsthand how the stock market reacted to the Federal Reserve's interest rate shock in 2022. By October, the S&P 500 had fallen almost 27% before rebounding slightly in the fourth quarter. Going back even further, the S&P 500's return between 1966 and 1982 was a cumulative 51% over those 16 years. That's a paltry compound return of less than 3% per year. But at least it's positive, right?
Not after accounting for inflation. The inflation-adjusted S&P 500 lost about half its value over that stretch.
Not everything was a flop during that time frame, of course. Gold enjoyed a monster run, rising from roughly $35 per ounce to $850 for a return of more than 2,000% in nominal terms. Commodities in general performed well, though this is partly skewed by the effects of the two oil shocks of the 1970s.
Real estate also proved to be a fantastic inflation hedge, particularly if it was leveraged. The median price of a new home rose from $23,400 in 1970 to $64,600 in 1980. If you had purchased your home with a mortgage before the 1970s, your leveraged return would have been several multiples of that … plus you got to pay back the mortgage in depreciated dollars.
Commercial properties were another winner, as landlords were able to raise their rents to keep pace with inflation. And farmland roughly quadrupled in value in the 1970s.
So, while inflation wreaked havoc on traditional "paper" portfolios, investors who had diversified into hard assets did just fine.
What about the Fed?
Inflation affects the way assets are priced. But it also impacts the underlying fundamentals. Inflation influences Federal Reserve policy, which in turn changes how fast the economy — and corporate earnings — can grow.
The Fed operates under a "dual mandate" from Congress: maximum employment and stable prices. When inflation runs hot, the Fed's playbook is to raise its benchmark federal funds rate to cool demand for borrowing.
Higher policy rates ripple outward into higher mortgage rates, higher corporate borrowing costs, and higher hurdle rates for new business investment. That's not a bug; it's a feature. The Fed is deliberately trying to slow the economy down enough to bring price growth back under control.
In this scenario, Nike (NKE) sells fewer shoes and Starbucks (SBUX) sells fewer lattes. Microsoft (MSFT) and Amazon (AMZN) build fewer data centers, which means Nvidia (NVDA) sells fewer chips. Sales and earnings growth cools, and that slower growth gets translated into lower stock prices.
This is why stocks struggle during inflationary times. Not only are their future earnings discounted more heavily into today's dollars, but the estimates of those future earnings are themselves revised lower.
What's different today for investors and what isn't?
It was a lot harder to diversify in the 1970s. Treasury Inflation-Protected Securities (TIPS) didn't exist until 1997. Commodity and gold ETFs didn't exist until the 2000s. And more exotic investments such as commercial real estate or farmland were too expensive and too complicated for the average investor to buy.
Today, an investor's biggest risk is being overwhelmed by choice. For virtually any inflation-fighting strategy, there are likely a half dozen off-the-shelf ETFs available to choose from.
So, how should we approach this as investors?
Make sure your portfolio is well balanced between stocks, bonds and inflation hedges like gold, commodities or real estate. You don't need to dump your stocks and bonds entirely, but introducing inflation hedges into the mix can reduce your risk and potentially boost your returns.
The beauty of diversification is that you don't have to get it exactly right. Being overweight or underweight by a few percent in any asset class isn't likely to make the difference between a luxurious retirement and total ruin. But having some inflation protection in the portfolio really can make a difference to your long-term returns.
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