Bonds serve two main purposes in a portfolio. First, bonds help to diversify a portfolio, often moving counter to stocks. Second, bonds help to reduce volatility. Over my 35 years investing in mutual funds, the long-term trend in bonds has often been clearer than the trend in stocks. If bond interest rates are historically high, they are likely to go down which means bond prices will go up. One of my early successes was riding this trend. Now interest rates are historically low and thus are likely to go up. This means that bond prices are likely to go down which of course is not good news for a portfolio including a bond position. Nonetheless, it makes sense for most investors to retain a bond position in order to reduce volatility.
Over a long period of time, the major disadvantage of bonds is their vulnerability to inflation. After all, if the price of a bond is stable and the value of the dollar decreases due to inflation, the overall result is negative.
My impression is that older investors who invested during the sixties and seventies are more worried about inflation than younger investors. There are two reasons for this. First, with age comes the appreciation of the power of inflation compounding over long periods of time. I remember gas less than 30 cents a gallon and hamburger for 43 cents per pound. I know that Motel 6 got its name from the fact that a room was $6 a night and Super 8 began by charging $8 a night. I used to bemoan the way my grandmother complained about the high cost of everything, but now I often feel the same way. The result is to understand that over time, inflation can eat away at the value of fixed price investments. A dollar really does not buy what it used to. The second reason is the understanding that debtors gain from inflation and creditors lose. This is important because of who is the biggest debtor of all: the US government. Not only does the US government have a large debt, it is likely to grow. The Republican strategy of using tax cuts to starve the government in the future has an obvious flaw; politicians of all parties, under pressure from their constituents, are inclined to spend money. I thought Federal Reserve Chairman Greenspan was at his silliest when he talked with concern about difficulties in the Treasury market if the US paid off its debt. (He did this as part of his support for tax cuts.) A rational person who has watched politics over a lifetime understands the many problems that require funding and has heard the political reasons to have tax cuts. With politics watching comes the recognition that there is no danger the US will pay off its debt. Since the US is a debtor and debtors gain from inflation, it seems likely there will be inflation in the future just like in the past.
We have had a period of low inflation. Since unions have less power, employees are in a weaker position to negotiate wage increases. Global competition and large retailers like Wal-mart act to keep prices down. But that period of low inflation seems unlikely to last. And even low inflation over a period of time compounds into significance. The possibility of inflation involves psychological factors, since if you think inflation is high, you will want a larger raise. If you think inflation is increasing, you are more likely to spend encouraging more inflation. One weapon in this psychological war strikes me as particularly interesting. That is the emphasis on "core inflation". This is the cost of living with food and energy stripped out. This certainly makes inflation look tamer, but it no longer seems to have much to do with the cost of living. (I guess the next step would be to strip housing out of "core inflation". Any suggestions for what to call the cost of living with food, energy, and housing all stripped out?) The Federal Reserve is committed to fighting inflation, but I don�t think you should expect victory.
How should you prepare for inflation in your portfolio? I first bought a TIP fund (inflation protected treasuries) in 2000 after reading Shiller's Irrational Exuberance. They have performed well, and, though no longer a bargain, they make sense if you are concerned about inflation. Real Estate is often seen as an inflation hedge but the real estate market seems overvalued. A natural resource fund is a possibility. TR Price New Era Fund was developed in a previous time when inflation was a concern, and I owned it for a 5-year period then. A commodity fund is an option available now that was not available in previous inflationary times, and such a fund has the advantage of being a good diversifier.
Inflation in the past has made a strong impression on my thinking and, as a result, I might be overly negative about inflation. As a result of global competition, inflation might remain tame. But I would not bet my portfolio on it.
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