By Dr. Jim Dahle, WCI Founder
2021 and 2022 were the first years in decades in which US investors faced significant inflation.
While inflation was in double digits for three years around 1980, it had not been over 5% since 1990 (or even over 3% since 2011). Then, wham! It was 4.7% in 2021 and over 7% in 2022, with year-over-year inflation peaking at more than 9% and monthly inflation peaking at 1.37% in June 2022. For years, investors have been talking about hedging against inflation, only to find out that most of these “inflation hedges” didn't really work when the rubber hit the road.
That is to say, those supposed hedges didn't go way up in value to help offset the rest of the portfolio when inflation did increase. Check out this list of asset class returns for 2022:
- Long-term bonds: -27.22%
- Short-term bonds: -5.54%
- US Stock Market: -19.53%
- International Stock Market: -16.01%
- Publicly Traded REITs: -26.20%
- Commodities ETF: 24.08%
- Oil ETF: 28.97%
- Gold ETF: -0.77%
- Silver ETF: 2.37%
- Bitcoin: -65%
- Long-term TIPS: -31.68%
- Short-term TIPS: -2.96%
- I Bonds: 5.45%
- G Fund: 2.98%
- Cash: 1.55%
See what I mean? Almost nothing “worked,” if we define “working” as having great returns in a year with bad inflation—or at least returns higher than inflation. Only two asset classes outperformed inflation. Oil and a broad commodities ETF (which is mostly oil) had great returns. However, it would take an investor with an iron stomach to have held that investment from 2007-2022 when it finally “worked.” The annualized returns for the Oil ETF were -13.39% per year for those 15 years, and even for the broader commodities ETF, they were -5.89% per year. Minus-13.39% is an absolutely horrendous performance. That means if you started with $100,000, you ended with $11,000 after 15 years. And that 15-year period includes 2022! It was even worse before.
Bonds and stocks certainly didn't work. Real estate had even worse returns. Gold, silver, and Bitcoin? Nope. Not even close. TIPS are supposed to hedge inflation, right? No, they were down about as much as other bonds. Cash and “cash on steroids” (the federal TSP G Fund) underperformed inflation by 4%-6%.
Only I bonds seemed to have a decent year, benefitting from the fact that they don't go down in value and yet still have their yield adjusted upward with inflation. How did my I bond investment do in 2022? I only made 5.45%, still less than inflation for the year. Now, it is true that the yield peaked at 9.62%, but I bought $20,000 of I bonds in December 2021, $20,000 in January 2022, and $10,000 in April 2022, and my overall return was only 5.45% for the year. To be fair, some of that return due to the high inflation in 2022 will come to me in 2023, but even so, I bonds have another issue—you can only buy so many of them in any given year.
You can hedge a $100,000 portfolio with them but not a $1 million portfolio, much less a $10 million portfolio.
The Good News
There is a silver lining to all this, of course. You don't actually need to hedge inflation in the short term. You need a portfolio that keeps up with inflation in the long term. Inflation has an erosive effect on your purchasing power, but even 7%-10% inflation in one year doesn't kill your portfolio. It's prolonged inflation that does so. And the good news is that there are many investments out there that can keep up with or beat inflation in the long run. You don't need to “hedge;” you just need to make sure your portfolio is growing faster than inflation in the long run.
TIPS, particularly when purchased individually, are exceptionally good at keeping up/beating inflation but only when held to maturity. If you buy a 1.5% 30-year TIPS, you, in 30 years, will have made 1.5% per year in real terms. They are very risky/volatile investments in the short term but riskless in the long run.
I bonds can make up a smaller portion of the portfolio of most high earners. Real estate—particularly when financed with low, fixed-interest rate debt—also tends to beat inflation long term. Publicly traded REITs had a lousy 2022 (and a catastrophic 2008, falling 78% peak to trough), but their 15-year return (6.31% per year) still beats inflation. US stocks have had a great run over the last 10 years, but even if you go back 15 (to include 2008), they still made 8.71%. Even international stocks, despite the strengthening of the dollar lowering their returns the last decade, have at least mostly kept up with inflation (3.99% 10-year annualized return, 1.59% 15-year annualized return). Even bonds made 2.61% per year over the last 15 years, which beats inflation.
Stop trying to hedge against inflation in the short term and simply build a long-term portfolio that will outperform it. Stocks, bonds (including some inflation-indexed bonds), and real estate are all you need to outrun inflation during your investment career.
What do you think? Did anything work for you in 2022? How do you ensure your portfolio beats inflation? Comment below!
This piece sure got me thinking about how inflation hits different investments. It’s got me scratching my head over these so-called ‘inflation safeguards’ when they couldn’t even match up with the wild inflation spike in 2021 and 2022. Oddly enough, only oil and some commodities ETF could run faster than inflation, even though they weren’t doing so hot in the past.
It might be good for some readers if you clarified that the TIPS you referred to in the long list are TIPS funds, not individual TIPS, because, as you noted subsequently, individual TIPS held to maturity will provide exactly their stated, inflation-adjusted yield.
Also, two other statements you made about TIPS aren’t quite accurate. Many people thought that “TIPS are supposed to hedge inflation,” but this was a false assumption. An investment hedge is “a [position] that is made with the purpose of reducing the risk of adverse price movements in another asset.” TIPS insulate the funds used to buy the TIPS from inflation beyond what the bond market expects to occur, but they don’t and never did extend any such protection to the remainder of one’s portfolio. In other words, there is no basis for an expectation that TIPS would provide a counter-balancing effect. Commodities are about the only asset I know of that may act as a counter-balance to unexpected inflation, but as you note, a long-term holding in commodities may result in poorer long-term returns.
Also, “[TIPS] were down about as much as other bonds” is problematic. in 2022, TIPS funds did indeed fall in value almost as much as the total bond market (which is only made up of nominal bonds), but in 2021, TIPS funds far outpaced TBM with a nominal return of +5.56% vs -1.77%. Over the period of 2021-2022, TIPS funds had a 4% higher annualized return than TBM. In bond terms, that’s substantial outperformance. The reason that TIPS funds went down in 2022 is because they are marketable bonds, and rising interest rates are bad for bond principal, even for TIPS.
All that said, I agree with you that short-term inflation ‘hedges’ are simply unnecessary. As Paul Merriman says, ‘a year in the market is just noise’. It’s hard for humans to fully realize that.
About individual TIPS held to maturity, there is no inflation risk, if taxes aren’t an issue. Also, inflation risk is an issue, if you end up needing to sell your individual TIPS prior to maturity.
Yes, taxflation is sadly quite real, and TIPS sold early may garner a lower dollar value than they wouldn’t if they were held to maturity.
Thanks for all those clarifying comments.
So how does a TIPS fund protecting “the funds used to buy the TIPS” from inflation differ functionally from TIPS funds providing the whole portfolio from a modicum of inflation?
TIPS only protect ‘themselves’ from unexpected inflation; they don’t offer any protection to the remainder of a portfolio. Therefore, the extent to which TIPS help to protect a portfolio from inflation depends entirely on how much of the portfolio is in TIPS. I’ve long advocated for individual investors’ default fixed income position to be 100% inflation-linked bonds (i.e., TIPS and I bonds). Those in high tax brackets might desire to take on some of the risk of unexpected inflation by also owning some muni bonds in return for potentially better after-tax returns.
– ‘there are many investments out there that can keep up with or beat inflation in the long run. You don’t need to “hedge;”’
Yes. BTW, that is one reason I suppose for why Buffett talks about “pricing power.” If you own a company’s stock without pricing power, guess how it’ll do when inflation takes its toll?
Hey Jim, great post as always. I would be concerned when I enter retirement that a year like 2022 would really amplify sequence of returns risk when inflation is super high, and every asset under the sun is tanking. in a sense retirement situations like 2022 or in the 73/74 bear market are instances where you have to hedge inflation in the short term because you are actively drawing from your nest egg. Do you think cash is really the only reasonable asset to have a hedge on a combination of high inflation/taking stock market/rising interest rates when in retirement?
The problem is that cash may not keep up with inflation either. Cash tracked inflation pretty well in the 1970s, but it hasn’t done nearly as well since 2009. I bonds track inflation as measured by CPI-U, are tax deferred, and don’t go down in value (unlike TIPS, which can because they’re marketable), but you’re limited to $10k per person per year, though you can buy a bit more via tax refunds. Still, if you spend enough time accumulating them, you might get enough to make a meaningful difference. If nothing else, you might have at least a year or two’s expenses in the event of another period like 2021-2022, kind of like a ‘break glass in case all other assets are down’ asset.
Yes, those are the real SORR moments aren’t they?
Taking risk with the portfolio is the main way to beat inflation in the long run. Another method is a TIPS ladder.
“Real estate had even worse returns. ” This baffles me. Real estate crushed inflation in those years. Maybe you are referring to REITs? I don’t follow those but they are basically stocks to me. Other investment real estate crushed it. I had some funds sell buildings much sooner than expected due to the huge valuations. Rents went up over 40% in a lot of areas but was overall significantly increased nationwide. Housing costs skyrocketed. My friend just told me he was informed his rent was about to go up over 30%. My SFH rental went up in value over 25% in that time frame without requiring any significant improvements. So what are your referring to that real estate didn’t beat inflation?
Jim is referring to ‘publicly traded REITs’. You’re right that a lot of real estate shot up during 2021-2022. Our primary residence increased in value over 30% during that period.
Every real estate property is different and there are precious few indices that can really measure how it is really performing. The most accessible one is a simple REIT index fund as I have used. There is also a private one (NCREIF) that is not as easy to use.
So the question for those who say “my real estate did awesome” when REITs tanked is
Which of the following really happened?
1) Your real estate did better than real estate in general
2) You didn’t realize that your real estate fell in value because it isn’t marked to market daily
3) Your real estate somehow performs differently if it is owned by a REIT versus if it isn’t
I assure you that many private real estate investments are struggling right now, particularly those financed with variable rate loans. Glad yours aren’t (or at least don’t seem to be).
Thanks for your response. I mean, yeah, you’re correct it’s hard to know the absolute value of a particular property until you sell (mark to market), but you get a pretty good idea based off comps from recent sales and the comps have me up that much. With respect to “your real estate did better than real estate in general” comment, the whole market jumped a bunch during those high inflation times. These values didn’t just jump on my properties.
Just to prove my point, average home price in Jan 2020 was $268k and as of May 2023 is $397k (https://dqydj.com/historical-home-prices/). I think that beat inflation. For commercial properties, it’s based more off what the properties make. Cap rates have gone up but the value of my commercial property is still up approx 24% from when I purchased it Jan ’22 when you look at comps that have sold recently.
As I mentioned, REITs are closer to stocks than real estate. So yes, I believe private real estate behaves differently than REITs. Many predicted a big drop in home prices and it really didn’t happen. Small and very brief pull back recently but they are going up again because no inventory.
You are correct that there are some struggling who got short term loans with balloons coming due but it’s not nearly as bad as the media is making out to be. Plus, it’ll mostly affect certain RE classes like office space. I’ll just say that most of the people I know if RE are doing quite well. The only real negatives I hear from investors is that it’s just hard to find deals because inventory is so low and rates are high to make the deals work. But not buying is different from losing properties to foreclosure. Foreclosures are still way below normal national averages.
This all being said, if you are simply referring to REITs than you are correct. Just in the article it’s leading people on that all real estate didn’t beat inflation which isn’t accurate.
Data is not the plural of anecdote. If you look at the DATA, you see a different picture.
Here is median sales home price.
https://fred.stlouisfed.org/series/MSPUS
You’ll note that it peaked at $479,500 Q4 2022 and is currently at $416,100 Q2 2023. That’s a decrease of 13.2%.
NCREIF Total Return shows:
https://ncreif.org/__static/0966fe406072de076fcd80a33b6b6a64/odce-press-release_-1-q-2023.pdf?dl=1
down 5% in Q4 2022 and down another 3% in Q1 2023.
https://www.ncreif.org/data/index-returns/
It’s down another 2% in Q2 2023. That’s three quarters straight of declines and about 10% total. That’s private real estate.
Public real estate (which gets marked to market much more frequently) is easily tracked by looking at an index fund in the space such as VNQ.
Since it is more forward looking due to being traded on the stock market, the bad returns come earlier. We see them in Q1 2022 (-5.97%), Q2 2022 (-15.48%), and Q3 2022 (-10.94%). The last three quarters have been up.
Here’s the Case Shiller database: https://fred.stlouisfed.org/series/CSUSHPINSA
again showing a drop from the peak (although not a huge one).
I don’t know of any other real estate DATA out there, but what we do have certainly does not paint the rosy picture you are describing. Thus, you’re either wrong, or your real estate is doing better than average. Hopefully the latter.
But I don’t think you can say my statement is inaccurate because you somehow believe that if a property is put in a REIT its value magically, instantly changes. “It’s just a stock”. Yea, a stock that owns a bunch of real estate and is primarily valued based on what the market thinks the real estate it owns is worth.
But if you’re just saying that real estate did awesome in 2020-2021, I totally agree. Guess what bears that out? The data. Even the publicly traded REIT data. (up 40% in 2021)