WILL INDEX FUND INVESTORS SURVIVE INFLATION?

Inflation continues to be the big topic on investors’ minds—for good reason.  As the price of the goods and services we regularly consume go up, living becomes more expensive and we either have to devote more of our income or savings to maintain our living standards, or for the same amount of income we must accept that some elements of life are no longer possible.  Simply stated, inflation is a problem worth worrying about.

Investors need to focus on the growth of their portfolios, even in retirement, to ensure they don’t experience a considerable loss of purchasing power.  People saving for retirement are simply trying to grow their investments so that they’ll have more than necessary to avoid the corrosive effects of inflation on their future income.  This means everyone has to own stocks, and lots of them.

But which stock approach works best?  In a recent article I looked at different stock and bond asset class indexes and their behavior during the last period of sustained higher inflation.  But because we don’t buy asset classes, we own portfolios, in today’s note, I want to look at this from a slightly different angle—comparing the ever-popular “basic indexing” approach that focuses mainly on US large cap stocks, versus a more modern (but less well known), globally-diversified approach with added exposure to small cap and value stocks, also known as “asset class” investing.  This is very much a hypothetical comparison between how most people invest today (basic indexing) and how Servo says to do it.

Let’s look at the period from 1970 (first year of data for the DFA Equity Balanced Strategy Index) to 1981, a stretch of 7.9% per year inflation.  We’ll be reviewing CPI (inflation), the S&P 500 Index, the similar Vanguard US Total Stock Index as measured by the CRSP 1-10 Index (all of the stocks in the US market but with a strong bias towards the largest growth stocks), and the globally diversified, small cap and value-tilted Dimensional Equity Balanced Strategy Index (portfolio weights at the end of the article).

First, let’s bring up a misconception about stock investing—stocks are not an inflation “hedge.”  They don’t beat inflation all the time—not every month, every quarter, or as the table below shows, every year.  For the 12 years ending in 1981, the S&P 500 and Vanguard Total US Stock Index beat inflation six times and trailed six times.  In a foreshadowing of thoughts to come, the Dimensional Equity Balanced Strategy Index beat inflation eight times, but still underperformed in four years.

But the case for stocks as a defense against higher inflation doesn’t entail that they always beat inflation, only that they eventually do.  Remember, we’re not investing money we need in six to 12 months into stocks.  We’re talking about long-term goals: a secure retirement, an income we don’t outlive over the three decades after we’re done working, and/or a financial legacy for those we will one day have to leave behind.

When we look at the entire period, the circumstances improve.

Despite the fact that US large cap stocks—the S&P 500 and Vanguard US Total Stock Index—beat inflation six times, their underperformance completely offset their outperformance and we can see below that these approaches were unable to keep pace with inflation.  Investors in this common investing approach endured a 12-year period with no returns net of inflation.  That’s devastating for hard-earned wealth with meaningful long-term goals.

The Dimensional Equity Balanced Strategy Index, on the other hand, soared past inflation.  Strong returns from small cap value and international stocks offset disappointing results from the S&P 500.  Diversified investors (the Equity Balanced Strategy Index includes 20% in the S&P 500 Index!) didn’t feel nearly the sting of higher consumer prices as those who bet everything on a handful of large US growth companies.

What were the actual returns over this period?  The table below reports the statistics.

The S&P 500 returned 1% per year less than inflation, the Vanguard US Total Stock Index (CRSP 1-10 Index) trailed by 0.7% per year.  These were not losses in the traditional sense, but net of inflation, losses none the less.

Despite two annual losses for the Equity Balanced Strategy Index, and four years of underperforming inflation, the good years far outweighed the bad and the diversified approach outpaced inflation by 6% per year.  That’s a resoundingly better result than the common US large cap/basic indexing approach to investing.

Will stock index fund investors survive higher inflation? If history is any guide, the answer very much depends on how you’re invested.  

The largest US blue chip stocks, which most investors have a lot of their portfolio in if they’re following a basic index fund approach, have not fared well during periods of higher inflation.

If, instead, you’re holding a more diversified portfolio—one that includes small cap stocks, value stocks, and international stocks for example—we’ve seen that this balanced approach has fared much better when consumer prices march relentlessly higher (as well as when they don’t).

The advice to diversify your investment portfolio is always sound.  But considering the economic environment of today, with inflation higher than we’ve seen at any point in the last 40 years, it’s more important than ever that you follow this proven strategy.

If you are having trouble figuring out the right way to diversify your portfolio, or would like a 2nd opinion on your current retirement investment plan, click this link to schedule an introductory 15-minute chat with me.

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Dimensional Equity Balanced Strategy Index = 20% S&P 500 Index, 20% DFA US Large Value Index, 10% DFA US Small Cap Index, 10% DFA US Small Value Index, 10% DJ Wiltshire REIT Index, 10% DFA International Value Index, 5% DFA International Small Cap Index, 5% DFA International Small Value Index, 3% DFA Emerging Markets Index, 3% DFA Emerging Markets Value Index, 4% DFA Emerging Markets Small Cap Index, rebalanced monthly. Data provided by Dimensional.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.