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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.

This chart tracks the US inflation rate since 1950. There have been some dizzying spikes in the inflation rate over the past decades, including over 14% in 1980. Despite some big jumps the average inflation rate has been about 3.5%.
Source: Bloomberg Finance, LP as of August 31, 2022.

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.

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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.

Over the past century, when inflation was 4% or more, a balanced, diversified portfolio far surpassed cash returns over the subsequent 3-, 5-, and 10-year periods. For periods of inflation under 4%, the average return on a balanced portfolio was 7% over a 3-year and 5-year horizon. It was 6% over 10 years. Cash returned 1% over 5 years and 0% over other time periods. In periods of inflation greater than 4%, portfolio returns averaged 5% over 3 years, 4% over 5 years, and 6% over 10 years compared to 1% for cash over 10 years, and 0% over shorter time periods.
Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. It is not possible to invest directly in an index. Balanced Portfolio: 42% Domestic Equity—Dow Jones US Total Stock Market Index; 18% Foreign Equity—MSCI ACWI ex USA Index; 35% Investment-Grade (IG) Bonds—Bloomberg US Aggregate Bond Index, 5% Cash—Bloomberg 1–3 Month T-Bills. Inflation: 12-Month rolling CPI-Urban Index. Returns are calculated starting in inflation period but include all subsequent periods for their holding horizon. Source: Bureau of Labor Statistics, Haver Analytics and Fidelity Investments (AART). Asset class total returns are represented by indexes from the following sources: Fidelity Investments, Bloomberg, ICE BofA. Fidelity Investments source: a proprietary analysis of historical asset class performance, which is not indicative of future performance, as of 4/30/22.

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.

Historically during periods of higher-than-average inflation, commodities tend to perform better than bonds in the late-cycle expansion. Once recession risk becomes the dominant theme in the economy, fixed income tends to outperform. Tilting toward more-defensive exposures during recessions may provide diversification benefits regardless of inflation. The annualized average real return of commodities in the late cycle has been 1% in low inflation regimes during the late cycle and 24% in high inflation regimes. Investment grade bonds were 3% under low inflationary regimes and -4% under high inflation.
For illustrative purposes only. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. It is not possible to invest directly in an index. Fidelity proprietary analysis using historical index returns. Domestic Equity—Dow Jones US Total Stock Market Index; Commodities—Bloomberg Commodity Total Return Index; Investment-Grade (IG) Bonds—Bloomberg US Aggregate Bond Index. Source: Fidelity Investments (AART), as of 4/30/22. *High inflation refers to periods when inflation is greater than the long-term average inflation rate, or a low inflation period otherwise.

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.

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This information is intended to be educational and is not tailored to the investment needs of any specific investor.

1. As measured by the Dow Jones US Total Stock Market Total Return IndexSM between 09/30/2012 and 10/24/2022. The annualized 10-year total return was 12.12% and the average rate of inflation over that time period was 2.32%.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for investments that focus on a single country or region.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Investing involves risk, including risk of loss.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Fidelity advisors are licensed with Fidelity Personal and Workplace Advisors LLC (FPWA), a registered investment adviser, and registered with Fidelity Brokerage Services LLC (FBS), a registered broker-dealer. Whether a Fidelity advisor provides advisory services through FPWA for a fee or brokerage services through FBS will depend on the products and services you choose.

The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.

​The Chartered Financial Analyst (CFA) designation is offered by the CFA Institute. To obtain the CFA charter, candidates must pass three exams demonstrating their competence, integrity, and extensive knowledge in accounting, ethical and professional standards, economics, portfolio management, and security analysis, and must also have at least four years of qualifying work experience, among other requirements. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Indexes are unmanaged. It is not possible to invest directly in an index.

Index definitions

The Dow Jones US Total Stock Market IndexSM is a market-capitalization-weighted index that includes all US companies with readily available prices across all market-cap sizes.

Bloomberg Commodity Index Total Return measures the performance of the commodities market. It consists of exchange-traded futures contracts on physical commodities that are weighted to account for the economic significance and market liquidity of each commodity. This benchmark was formerly known as the Dow Jones-UBS Commodity Index Total.

The Bloomberg US Aggregate Bond Index is an unmanaged market-value-weighted index for US-dollar-denominated investment-grade fixed-rate debt issues, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year.

The MSCI All Country World Ex-US Index is a recognized benchmark of non-US stock markets. It is an unmanaged market value-weighted index composed of a sample of companies representative of the market structure of 49 countries and includes reinvestment of all dividends. The MSCI AC World Ex-US Index, when including or excluding securities, takes into account any limitations that an international investor would experience when investing directly in such securities. The index contains both developed and emerging market securities.

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