Almost everyone fails the investment literacy test

Are you ready for today’s retirement investing pop quiz?

Which of the major asset classes is most correlated with inflation, performing better when inflation is higher and worse when it is lower?

I bet you answered gold or maybe commodities in general. And you are not wrong, undefined you focus on the correlation of short-term movements. This is illustrated by the accompanying chart, which plots the correlation coefficient between inflation and stocks, Treasuries (both intermediate and long-term), commodities (as measured by the S&P GSCI index), and gold.

Notice, however, that when you expand your focus to multi-year periods—as indeed retirees and near-retirees must do when planning for retirement—the answer changes dramatically. In fact, when we focus on all 10- or 20-year periods since 1970, medium-term government bonds have the highest correlation with inflation.

Virtually no one I give this pop quiz to gets this right.

How can intermediate Treasuries have this counterintuitive relationship with inflation? The answer has two parts, one has to do with how the bond market works, and the other has to do with the importance of the time horizon when making your financial plan.

Read: US adds 315,000 jobs in August The job market is still strong but showing signs of cooling.

Why bonds are linked to inflation in the long run

In the short term, of course, higher inflation is bad for bonds as interest rates rise. We’ve seen this in spades over the past year as inflation has heated up to levels not seen since the early 1980s: The Bloomberg Global Aggregate Total Return Index (a benchmark representing the global investment-grade bond market) this past week entered a bear market for the first time in at least 30 years.

What relatively few investors appreciate, however, is that bond portfolios gradually recover lost ground over time. This is because they are able to reinvest the proceeds of any maturing bonds into new ones with higher yields. If you hang on long enough, then the return on your bond portfolio will almost match that of the higher interest rates that initially led to so many losses.

The length of time required is a function of the average duration of the bonds you own, with longer-duration bonds taking longer to recover in the face of higher inflation. This is why, in the accompanying chart, medium-term government bonds have a higher correlation with inflation than long-term government bonds. If I were to extend the length of the rolling periods that the chart focuses on, the long-term correlation of Treasuries with inflation would rise to match that of medium-term Treasuries. (However, I was unable to extend the chart in this way because with only 50 years of data, there are not enough rolling 30- or 40-year periods.)

Consider the performance of medium-term government bonds during the high-inflation era of the late 1960s and 1970s. In Wall Street’s imagination, this era is one of the worst in US bond history. But it really wasn’t as dire as we’d been led to believe, at least for medium-term government bonds. From the mid-1960s to the late 1970s, when 10-year inflation rose from an annual rate of 1.7% to 7.4%, the median 10-year Treasury yield rose from 3.1 % on an annual basis to 7.0%.

The investment implications: Provided your investment horizon is a decade or two, and you’re not investing in bonds with longer than medium maturities, you can be relatively indifferent to what inflation and interest rates do in the very short term.

Stock up for the long term

What about stocks? The same conclusion applies to stocks, with one important qualification: Your investment horizon must be a lot long before you can remain indifferent to inflation and interest rates.

How long? In response, I refer you to a column from a month ago in which I discussed research that found this required length of time to be more than 40 (!) years. This is a sobering finding, as few of us have such a long investment time horizon, even if we are not yet retired. This, in turn, means that in terms of our stock portfolios, we cannot be indifferent to the bear markets that may occur along the way – despite constant assurances from financial planners around the world that the long term will save us.

It is a reflection of the stock’s greater risk that this required holding period is so long. Stocks’ superior long-term, inflation-adjusted returns compensate for their greater risk. In fact, of any of the major asset classes, stocks come out on top over very long time horizons. But in order to realize that greater return, you have to take that greater risk.

This is another reason why bonds continue to play an important role in our retirement portfolio. By creating a diversified portfolio that includes both stocks and bonds, you can reduce the amount of time you need to be indifferent to bear markets down the road.

The bottom line: If possible, bonds are even worse right now than stocks. But a sober review of history suggests they continue to play a role in our portfolios.

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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