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Financial Opinion and Insights

How Does Inflation Affect the Markets?

IFG BlogDo all markets react to economic forces the same way all the time?  As any good consultant worth his salt will tell you, “It depends.”

Asset classes, for some reason, seem to have this annoying habit of reacting differently to different environments – probably because investors react differently to varying environments, and all these indexes we keep talking about are only reflecting what investors are doing with their money.

For example, it should come as no surprise to most that bonds and commodities generally react differently in high inflation environments, whether inflation is rising or falling.

Here’s a chart from JP Morgan Asset Management that depicts how different asset classes have reacted to varying inflation environments since 1972.  It’s important to remember this represents a forty-year period and that during those forty years, these asset classes have rarely moved in tandem.

Which environment are we in now?  It depends on what inflation number you use.  While the core consumer price index (CPI) excluded food and energy, the broad CPI today isn’t too different from the median CPI reflected above.   Since we seem to be coming off a low inflation base and can realistically expect a rising inflation scenario – the government hasn’t stopped printing money – the lower left quadrant does get our attention.

Does this mean you should avoid bonds and cash?  Not likely.   Asset allocation is about diversifying risk – and that’s all about blending correlations in a way that brings portfolio volatility (standard deviation) in line with a given investor’s risk profile.

The central question to the puzzle:  How can we best diversify assets to achieve an investor’s long-term goals while staying within defined risk parameters? 

That’s the $64,000 question.  And, for many people, not knowing the answers or how to allocate assets, has been far more expensive than that.

Jim Lorenzen, CFP®, AIF®

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Jim Lorenzen, CFP®, AIF®Jim Lorenzen, CFP®, AIF® is founding principal of The Independent Financial Group,  a fee-only registered investment advisor serving retirement plan sponsors and selected private clients.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  IFG also does not provide tax or legal advice.  The reader should seek competent counsel to address those issues.  Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan.  The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com  and by subscribing to IFG Insights letters  for corporate plan sponsors and individual investors.  Follow Jim on Twitter: @JimLorenzen

Written by Jim Lorenzen, CFP®, AIF®

June 7, 2012 at 8:00 am

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