Hedging your Investment Portfolio against Inflation
What assets should you own to protect your wealth from inflation?
Legendary investor and hedge fund manager Ray Dalio has come up with an All Weather Portfolio designed to withstand all economic seasons. I first heard about Dalios All-Weather Portfolio when reading Money: Master the Game by Tony Robbins (https://amzn.to/3uE8nqg). The premise of the all-weather portfolio is that there are four different economic seasons. Different asset classes tend to perform better or worse depending on the economic climate that is best suited to the asset class. The four economic seasons Dalio outlines are variables of a combination of two powerful forces: inflation and economic growth. The four economic seasons can be summarised as follows:
- Rising economic growth and rising inflation
- Rising economic growth and slowing inflation
- Declining economic growth and rising inflation
- Declining economic growth and slowing inflation
2022 has been a tricky year for investors and economic policymakers to navigate. We are currently experiencing a period of rapidly rising inflation and slowing economic growth off the back of the COVID-19 pandemic and the Russia-Ukraine war. So, while economic growth and activity are slowing down the costs of living are also rapidly rising. This is a particularly difficult season to weather, and this has been highlighted by a large sell-off in a variety of asset classes including both local and global equity and cryptocurrency.
In this particular climate Dalio recommends investors hold the following assets:
Gold's value is derived from its scarcity as a commodity, as well as its long economic history as a stable medium of exchange. The price of gold tends to rise during economic uncertainty and when inflation is high. This is because gold is seen as a safe-haven asset. The returns on gold versus stock tend to be inversely proportional, which means that when stock prices fall, gold prices tend to rise. This is however not always the case as there may be certain market conditions which may cause both gold and stock prices to fall or vice versa. Year to date, the gold price has remained flat while the stock market has seen a large sell-off. Therefore, if you held a large portion of gold, your portfolio would be far better off in 2022 than someone with mostly equity.
Commodities are the raw inputs used in the production of goods. They may also be basic staples such as certain agricultural products. Commodities can be bought and sold on specialised exchanges as financial assets. Commodities typically trade on the derivatives markets as future, forward or options contracts.
Emerging Market Bonds
An emerging market bond is a fixed-income debt instrument that is issued by developing economies. Emerging market bonds offer much higher yields than the bonds of developed market economies. Emerging economies however carry a higher level of risk as the government of the economy may default on the debt. An example of an emerging market bond would be South African government bonds given that South Africa is classified as an emerging market economy. More developed countries such as the United States, France and Japan are classified as developed market countries and these bonds tend to offer a much lower return. As a point of comparison South African 10-year bonds currently have a yield of 10.64% whereas US 10-year bonds only have a yield of 2.98%.
Inflation Projected Bonds
Inflation-protected bonds are securities designed to help protect investors from inflation. Inflation-linked bonds are typically issued by the government and have a rate of return linked to the consumer price index which is used to track inflation. Inflation-linked bonds are a useful tool to protect your wealth from inflation.
As Ray Dalio suggests, owning a well-diversified portfolio with multiple assets classes is the best way to diversify against large drawdowns in your portfolio. It is important to have assets with an inverse correlation to the stock market that can help keep your portfolio afloat in times of pessimism in the global equity markets. If you do not currently own any of the asset classes touched on in this article is may, be useful to do some further research as to whether you should allocate a percentage of your portfolio to gold, commodities, emerging market bonds or inflation linked bonds.