Inflation is perhaps the biggest enemy of a would-be retiree, eating away at the value of core investments virtually across the board – the 70s shook investors to their core, causing many to flee stocks and bonds in favor of alternatives. No one wants to see a sequel to that scenario, but despite the uniqueness of the wage-price spiral that precipitated it, there is no ruling it out, either, in the short or the long term.
Deflation protection is built into most portfolios – particularly those containing intermediate to long-duration bonds. A comparable (let alone perfect) inflation hedge, meanwhile, simply does not exist. However, there are asset classes that have performed better under inflationary pressures than others and are well worth considering. Small cap stocks and inflation-indexed bonds are two that generally produce positive real returns during inflation and deflation, while commodities and Treasury Bills may be worth considering as well (though they may only work for beating high inflation or trailing-but-tracking inflation, respectively).
First, as shown in the initial image above (via Fidelity) foreign stocks and long-term bonds are certainly no safe haven in a dollar-devaluing storm. TIPS, government bonds tied explicitly to the CPI, naturally track inflation to some degree, but not perfectly thanks to shifting interest rates. Treasury Bills historically tend to follow inflation due to rapid turnover, but when held artificially low via government intervention they can lag significantly as well. Commodities have no real expected return beyond perhaps some insurance-creation premium, but have also historically correlated with inflation along the same lines of TIPS and ultra-short Treasuries (as they track the cost of real goods and materials).
Still, that paints too broad a picture – the reality is that the degree of inflation makes a significant difference. As shown above, in Quintile 1 (low to negative rates) commodities are handily clobbered, Treasuries and small cap stocks lag. In Quintile 2 (slightly low to typical rates) small caps turn around and outperform modestly, Treasuries and commodities pick up their pace. In Quintile 3, commodities, REITs and stocks in general (USA domestic and foreign) all perform fairly well on average, while bonds lag. Up in Quintile 4 things get interesting, as most investments slip behind fairly equally compared to commodities, which shine. Then in Quintile 5 (very high inflation), it pays to be short on bond duration, light on large caps, and heavy on REITS, small caps and commodities.
While none of this is meant to suggest a definitive solution, it does indicate that some out-of-favor investments (arguably: REITS, commodities and small caps – all doing somewhat poorly as of late) may be worth keeping in mind for future inflation. Of course, for all anyone knows, we could be headed for a long period of deflation as well – but it pays to be prepared, and some of these investments (again: small caps, for instance) tend to do alright at either extreme, while others (e.g. TIPS) are at least protected from one (deflation) while benefiting from the other (inflation).
Most of all, when you break these options out by time, as in the last illustration, you will notice that each decade showed a different winner – just another reminder to remain diversified at all times. A good place to start, for those skeptical of keeping cash or commodities on hand, is that Small Cap Value indexes have an extra helping of REITs, and thus serve double-duty as both a tilted equity holding for higher risk/return but also a potential inflation hedge (and perhaps a good excuse to hold more inflation-linked bonds, too). In times of modest to high inflation, even if stocks lag, small and value companies (more likely to be in debt) may to some extent benefit beyond their more profitable or established brethren. Finally, in hyperinflation, all bets are off – causes and effects of history can only tell us so much about the future, especially in extreme Black Swan type cases. One can hope that nothing would happen to undermine TIPS, though – and if it did, we would likely have larger problems on our hands.