Most of us think of the return on our investments in nominal terms, or the stated return on an investment. In periods of low inflation, if you expect a corporate bond fund to yield 5 percent, thinking of this as a 5 percent return may not be particularly harmful.
When inflation increases, however, thinking in nominal terms can be very detrimental, especially to your long-term investment planning. Given recent events, it may be prudent to consider the next stage of the economy. The government has aggressively increased spending, and the Federal Reserve, the U.S. central bank, has increased the money supply. If inflation results from these measures, thinking in nominal terms may reduce the probability of satisfying your needs and goals. Now may be a good time to think about your portfolio return above the rate of inflation, or in real terms, and to prepare for the risk of higher inflation.
Inflation reduces investment returns and needs to be considered in constructing portfolios for different stages of investors’ lives. Most investors want their investment portfolio to preserve and enhance purchasing power. Preserving purchasing power means that investment returns must clear the inflation hurdle.
Investment insight
Nominal return: The stated return on an investment. If you invest $100 and get $102 in a year, that is a 2 percent nominal return.
Real return: The return on an investment adjusted for inflation (or deflation). A 2 percent nominal return in a 2 percent inflationary environment will leave you exactly where you started in terms of purchasing power, unless you are paying taxes on the interest, in which case you are worse off after a year. Your goal should include maintaining purchasing power, or your ability to pay for your future.
Let’s look at different securities in your portfolio to determine whether they are likely to meet the inflation hurdle.
Cash/short-term bond fund
Cash investments, such as savings accounts and money market funds, will often yield less than the inflation rate, reducing your portfolio’s real return. While cash serves a useful purpose, it may be beneficial to consider a high-quality short-term bond fund for some of your liquidity needs.
The somewhat higher yield in a short-maturity bond fund can help to keep pace with inflation. Remember, however, that returns that seem too good to be true often entail unexpected risks, so proceed with caution. Review the latest prospectus to understand the fund manager’s strategy and recent holdings. You may choose to skip a fund that contains securities with unfamiliar characteristics.
Bonds
Medium- and longer-term bonds typically do poorly in periods of higher-than-expected inflation for two reasons. Inflation erodes the purchasing power of a bond’s fixed income stream. In addition, unexpected increases in inflation typically result in rising interest rates, which lower nominal bond prices.
Inflation-protected bonds are an important exception to the behavior of most bond investments in inflationary periods. These bonds protect investors against unanticipated inflation explicitly, because they promise to pay a real rate of return plus actual inflation. In the United States, they are called TIPS (Treasury inflation-protected securities) and can be purchased individually to a target maturity date or within a fund that holds a diverse basket of maturities. Their special properties make them useful for investors who place paramount importance on maintaining purchasing power and desire the safety of a government-guaranteed bond.
While TIPS offer protection against unexpected inflation, they share with conventional bonds the sensitivity to changes in interest rates and market sentiment. Note, however, that hold-to-maturity investors would still receive the payments, including adjustments for inflation, for which they bargained when they bought the security (regardless of changes in the quoted value of the bond). Work with your financial adviser to evaluate the role that TIPS can play within your portfolio.
Investment insight
Treasury inflation-protected securities (TIPS): Treasury inflation-protected securities, or TIPS, protect against inflation. The principal of TIPS increases with inflation (and decreases with deflation) as measured by the Consumer Price Index (CPI). When TIPS mature, you are paid the adjusted principal or original principal, whichever is greater. Speak with your investment adviser about the tax treatment of the annual principal adjustment.
Stocks
Stocks are generally thought of as good inflation hedges over the long run because companies are able to charge higher prices to offset rising costs. Stock returns, however, may lag inflation, especially over shorter horizons. The recent decline in the stock market should underscore that equity investing is not for everyone or for every investment need. Match your goals and risk tolerance with an appropriate mix of investments.
Commodity funds
Sophisticated investors may address concerns about inflation by investing in commodity funds, which have value that fluctuates with prices of physical goods such as agricultural products, metals, and oil. Actively managed funds within this category tend to concentrate on a narrow range of positions, and consequently can experience more volatile results than other fund types. Additionally, some funds invest in companies that produce commodities, while others invest directly in the underlying commodity, which generally offers better diversification benefits. In general, commodity funds may serve the interests of longer-term sophisticated investors, often representing a small percentage of their portfolio.
Investing amid uncertainty
Recent market developments underscore the importance of following the evergreen Scouting principle of “being prepared.” Prudent investment planning suggests constructing a portfolio that will meet your needs and goals over a range of possible scenarios. While it is impossible to know with certainty how damaging inflation will be in your investment future, being prepared for the full range of possibilities, including a period of inflation, can make sense.
Why choose a CFA charterholder wealth manager?
Many investors use specialists for the complex matters of life, and portfolio construction is a good example. Consider using a financial adviser who is a CFA charterholder to assist you in constructing a portfolio that will meet your needs and goals.
Today’s financial markets demonstrate just how important it is to have reliable evidence of your financial adviser’s integrity, experience, and commitment.
No credential is as widely regarded in the global financial industry for its rigorous focus on current investment knowledge, analytical skill, and fiduciary responsibility as the Chartered Financial Analyst (CFA) designation.
A CFA charterholder is:
Credible. Adherence to a code of ethics that puts the client’s interest first and mastery of a comprehensive body of investment knowledge
Committed. Demonstrated professional experience and perseverance to undergo 18 hours of examination
Current. Exams updated with the latest and most relevant knowledge and access to world-class lifelong learning resources
Connected. Membership in a network of more than 100,000 investment professionals in 131 countries
source: CFA Institute Newsletter
Crew Capital Management Thoughts on Investment
Welcome to the Crew Capital Management Thoughts on Investment blog. At Crew Capital, investment education is key to how we work with our clients. We hope our conversation and analysis entice you to think further on your investment strategies and planning. For further discussion, please contact us at rjung@crewcapital.com
Thank you!
Robert F. Jung, CFA CPA*
*CPA inactve
Thank you!
Robert F. Jung, CFA CPA*
*CPA inactve
Wednesday, September 16, 2009
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Nothing on this web site shall be construed as advice to any particular investment need or investor. All references regarding investment or portfolio returns are based on historical data. One should not assume that this performance will continue in the future as past performance or results are not an indication of future performance or results.
Certain portions of Crew Capital’s web site (i.e. books, newsletters, articles, commentaries, etc.) may contain a discussion of, and/or provide access to, Crew Capital’s (and those of other investment and non-investment professionals) positions and/or recommendations as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current position(s) and/or recommendation(s). Moreover, no client or prospective client should assume that any such discussion serves as the receipt of, or substitute for, personalized advice from Crew Capital or from any other investment professional. Crew Capital is neither an attorney nor accountant, and no portion of the web site content should be interpreted as legal, accounting or tax advice.
At certain places on this site, live "links" to other Internet addresses may be accessed. Such external Internet addresses contain information created, published, maintained, and otherwise posted by institutions or organizations independent of Crew Capital. Crew Capital does not endorse, approve, certify, or control these external Internet addresses and does not guarantee or assume responsibility for the accuracy, completeness, efficacy, timeliness, or correct sequencing of information located at such addresses. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness. Reference therein to any specific commercial product, process, or service by trade name, trademark, service mark, manufacturer, or otherwise does not constitute or imply endorsement, recommendation, or favoring by Crew Capital.
Crew Capital enters into a new client relationship only after it provides and obtains certain information. In addition, Crew Capital may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Every prospective Crew Capital client is provided with a copy of Crew Capital ’s Privacy Policy, Form ADV Part II and Form ADV Part II Schedule F. Also, the USA Patriot Act, passed in response to the events of September 11, 2001, requires certain financial service providers to request specific information from clients. Accordingly, Crew Capital acts to verify a potential client's identity and makes a risk assessment of their financial and business activities. Lastly, Crew Capital will not provide any investment advice or supervision without a fully executed Investment Advisory Agreement.
As a registered investment adviser, Crew Capital is required by rule to adopt and enforce a code of ethics that establishes the standards of conduct expected of all employees and reflects our fiduciary duties. A copy of Crew Capital’s Ethics Policy will be provided to any client or prospective client upon request.
Nothing on this web site shall be construed as advice to any particular investment need or investor. All references regarding investment or portfolio returns are based on historical data. One should not assume that this performance will continue in the future as past performance or results are not an indication of future performance or results.
Certain portions of Crew Capital’s web site (i.e. books, newsletters, articles, commentaries, etc.) may contain a discussion of, and/or provide access to, Crew Capital’s (and those of other investment and non-investment professionals) positions and/or recommendations as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current position(s) and/or recommendation(s). Moreover, no client or prospective client should assume that any such discussion serves as the receipt of, or substitute for, personalized advice from Crew Capital or from any other investment professional. Crew Capital is neither an attorney nor accountant, and no portion of the web site content should be interpreted as legal, accounting or tax advice.
At certain places on this site, live "links" to other Internet addresses may be accessed. Such external Internet addresses contain information created, published, maintained, and otherwise posted by institutions or organizations independent of Crew Capital. Crew Capital does not endorse, approve, certify, or control these external Internet addresses and does not guarantee or assume responsibility for the accuracy, completeness, efficacy, timeliness, or correct sequencing of information located at such addresses. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness. Reference therein to any specific commercial product, process, or service by trade name, trademark, service mark, manufacturer, or otherwise does not constitute or imply endorsement, recommendation, or favoring by Crew Capital.
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