What inflation does to investments

When it comes to inflation, the past couple of decades have been unusually tame relative to the rest of modern history. In fact, from 2000 through 2020, inflation averaged about 2.1% a year, as measured by the US Consumer Price Index (CPI). Interest rates repeatedly hit record-setting lows over that time as well. Those were likely some great times for investors—and for borrowers—but it was an aberration historically speaking. That may help explain why today's 8.2% inflation rate feels so painful.

"If you go back long term, since 1950, the average US inflation rate has been about 3.5%. So inflation around 2% that we've experienced the last couple of decades isn't typical," says Naveen Malwal, CFA^®, institutional portfolio manager at Fidelity.

So inflation may be higher in the future than it has been in the recent past. Some broad, long-term themes playing out now could contribute to inflation risks in the future. They include rising debt levels, populist demands on governments, geopolitical instability, anti-globalization pressure, and widespread aging demographics. Learn more in Fidelity's quarterly market update: Market outlook: A challenging time.

Given those long-term inflationary trends, now's a good time to consider what they mean for your investments and take steps to try to help mitigate the impact of inflation on returns.

Brace for lower potential returns in the future

Despite higher inflation, financial professionals are optimistic that investments will still have positive returns. But it's possible that the real returns investors receive after inflation over the coming decade may not be as high as those from the past 10 years. The past decade saw an average annual return in US stocks of 9.58% after accounting for inflation.¹

"A balanced, diversified portfolio of stocks and bonds over 3-, 5-, and 10-year time periods has historically outperformed cash. During higher inflation periods it has still outperformed but just by a little bit less," says Jake Weinstein, CFA^®, senior research analyst in asset allocation research at Fidelity. "So you should expect in real, inflation-adjusted terms, slightly lower returns."

Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This may help reduce the volatility of your portfolio over time. Your investment mix can be diversified among stocks, bonds, and short-term investments. And it can also be diversified within those broader categories as well.

Even though stock and bond returns can be affected by inflation, they have generally outpaced short-term investments even when inflation has been high. In fact, when inflation is on the high side, a disciplined and diversified investment strategy may be more important than ever. Of course, diversification and asset allocation do not ensure a profit or guarantee against a loss.

Diversification may help fight inflation

Right now, the US economy is in the late-cycle phase of the business cycle. "That is the phase that warrants the most diversification of all phases," says Weinstein. "While stocks and bonds generally rise during late cycle, they also usually experience a lot of volatility."

Some investors—like the portfolio managers who work on managed accounts at Fidelity—make small changes to their investment mix based on the business cycle and other circumstances.

For instance, at the beginning of the year, compared to a 60% stock/40% bond investment mix, these client accounts were tilted a bit more toward stocks, real estate, commodities, and Treasury Inflation-Protected Securities (TIPS). They had less exposure to investment-grade bonds and short-term investments. As the economy entered the late-cycle environment, some modest changes were made, Malwal explains.

"In the late-cycle environment, the economic backdrop typically feels less certain and there are more bouts of market volatility, so we tend to lower the level of risk within well-diversified client accounts. By the end of September, a typical 60/40 portfolio had less exposure to global stocks than it did at the start of the year," Malwal says.

"We also increased exposure to investment-grade bonds. While bonds have been volatile this year, they have been less volatile than stocks, and we believe they can help manage risk within client accounts in the long run.

"Finally, we have less exposure to short-term investments as they may struggle to keep up with inflation because of their low yields. Instead, we have allocated some of that exposure to alternatives, commodities, and real estate stocks. Those can provide diversification benefits, along with some protection from inflation," he says.

Investments that may help fight inflation

For investors looking for ways to beat inflation Malwal suggests thinking about the types of businesses that can thrive under a variety of circumstances.

"When you think about the types of companies that can thrive when inflation is high, it's typically a company that is selling something that people need or will continue to use, even if prices go up," he says. "Outside of the US, there may be regions around the world that offer the opportunity to grow earnings despite what happens with inflation in the US. This may be particularly true for countries that produce commodities, which tend to rise when inflation is high."

Just like there are many types of stocks, there are many types of bonds out there. Investors seeking to manage the risk of higher rates have some options, including Treasury Inflation-Protected Securities (TIPS).

"Beyond TIPS, within our client accounts, there are a couple of other areas we're leaning into. For example, the higher yields available in high-yield bonds may help investors keep pace with or overcome inflation. These bonds are usually more volatile than investment-grade bonds, but their higher yields may be helpful," Malwal says.

Emerging-markets bonds may also offer attractive yields and are less directly impacted by inflation in the US and may benefit from factors in their local economies, says Malwal.

Finding investment opportunities

The next couple of decades may offer investors different challenges than the past, and that may call for new tactics.

"The world will be a different place over the next several decades and that warrants an active approach to portfolio construction," says Weinstein. "It may make sense to talk to your investment advisor about finding opportunities in the market to boost returns while hedging inflation."

If you're concerned about diversification or finding investments that can help fight inflation, consider working with an investment professional to help build a portfolio you can live with in any market.