Finding ways to beat tomorrow’s inflation

In a world in which defined contribution pensions are the norm (meaning investors themselves bear all the risks), combined with increasing longevity, a lack of awareness of the risks posed by inflation could have a severe impact on pensioners in just two decades. 

The good news is that, with sufficient time horizons, all assets have historically beaten inflation. It may be difficult to believe but this also includes cash in the UK. Logically this makes sense. Why would a rational investor put capital at risk of loss if the returns generated are not even enough to keep up with inflation? 

Investing to beat inflation is difficult because of the mismatch in volatility between different asset classes and the low volatility nature of inflation

The real difficulty in beating inflation time series is that they are relentless. Inflation is almost always positive, especially in the UK, which last year saw its first negative print for the headline consumer price index in decades. As a result, a cumulating inflation time series nearly always goes up in a straight line, unlike investable assets, which have price volatility in the form of mark to market moves. 

Investing to beat inflation is difficult because of the mismatch in volatility between different asset classes and the low volatility nature of inflation. As a result, investors should not expect to beat inflation with a month or even a year’s returns – it requires a reasonable time horizon. 

The question then is – how much does an investor need to exceed inflation by? If we agree that even cash should, in the fullness of time, provide returns in excess of inflation, it is fair to assume that inflation can be surpassed, albeit modestly, with relatively low-risk investments. 

Where investors want to beat inflation by a more meaningful amount, this demands a move up the risk curve. The riskiest asset class used by most investors is the equity market or a subsector thereof. The margin of outperformance of inflation has historically been far greater here, which is a reasonable expectation when considering the risk that has to be adopted.

The best way to reduce the volatility around the stable inflation returns series is to create diversified portfolios that have a genuine suite of differentiated returns drivers within them. 

To enable this, it may be necessary to hold some assets that are not expected to beat inflation over the medium-term but that are instead a decent stabiliser. There may be times when few asset classes display the necessary expected real return. This is a time for discipline to be applied. 

It would be all too easy to dominate a portfolio with the few attractively valued asset classes, but doing so would be unlikely to provide a suitable balance of risks to investors. This is why it is important to operate in a risk-rated environment. Remaining within a risk band is a vital discipline for investors. 

Long-term expected real returns from asset classes rely on performance from a whole range of valuation points; some good, others bad. Using valuation discipline to identify and avoid asset classes that are undervalued is a key returns enhancer for investors trying to beat inflation over the cycle. 

Other tools that help improve the profile of returns include making use of a global range of asset classes and sub-asset classes. 

It is imperative to be able to pinpoint opportunities with finesse, whether that be in regional or sectoral equity markets or even a particular part of the interest rate or credit curve. 

Within equity markets, it is also important to make use of style factors, because this is a very effective way of using highly volatile return streams that each have a unique stylistic tailwind to create a selection where the combination is far greater than the sum of the parts in terms of risk-adjusted returns. 

Improving risk-adjusted returns through means such as these is an effective method to enhance the probability of achieving the desired return in excess of inflation. 

But ultimately, it is imperative to move the debate forward with respect to what constitutes ‘risk’ to an investor. Thinking of risk purely in terms of volatility is a disservice for investors because in reality ‘risk’ is so much more than a number. 

One of the greatest risks that many savers are taking – often unwittingly – is the risk of having insufficient funds for a reasonable lifestyle at retirement, especially when the ravages of inflation have been taken into account. 

James Klempster is head of investment management at Momentum UK