Inflation Risk for Early Retirees – Part 4: Hedging

Here’s the next installment of the inflation series, joint with my blogging buddy Actuary on FIRE. Check out the other parts here:

Today’s post is about one issue I raised in the post last month: What asset classes – if any – are useful in hedging against inflation? Simple question, not an easy answer. It all depends on the horizon!

Keeping up with inflation over the long haul. And I mean really long haul!

To set the stage, let’s look at how different asset classes have helped to keep up with inflation over the decades. I have long-term return data on four asset classes: Stocks, Bonds, Cash (i.e. money market, short-term instruments), and Gold going back to January 1871:

  • Stocks: I use the S&P500 index (backfilled prior to the official index start), with dividends reinvested (i.e., Total Return Index)
  • Bonds: 10-year U.S. Treasury Bonds.
  • Cash: I have 3-month Treasury Bill returns since 1934 and backfill the returns prior to that with the 1-year T-bill returns.
  • Gold: The spot price in dollars, London Fixing.

Here are the cumulative real returns since 1871, so returns adjusted by the U.S. CPI inflation rates, see chart below. Equities leave all other asset classes in the dust! One single dollar invested in 1871 would have grown to over $14,000 by the end of 2017 if invested in stocks. But only about $45 if invested in bonds, $19 if invested in Cash (CDs, short-term instruments) and only a measly $2.90 if invested in gold (e.g., 1 ounce of gold).

InflationSeriesPart4 Chart01
Cumulative Returns: Stocks, Bonds, Cash and Gold. Stocks left everything else in the dust!

The large differences in the final value are, of course, due to compounding return differences over a very large horizon, almost 150 years. Equities returned about 6.7% real on average, more than four percentage points above the bond and cash return and 6 percentage points above gold return:

InflationSeriesPart4 Table01
Just in case someone asks: Average compounded returns since 1871, both nominal and real (CPI adjusted).

In other words, all four asset classes kept up with inflation over the very long-term. But that’s a low bar! And quite intriguingly, the one that’s normally seen as an inflation hedge, gold, has the least potential of outpacing inflation over very long horizons. Especially if we knock off another 0.25% from the high ETF expense ratios in, say, the iShares IAU ETF or 0.40% in the SPDR GLD ETF we are basically left with about zero real returns over the long haul. Someone, please page William Devane!

accident-994009_1280_SBR copy

In fact, the only asset class that had any chance at all to not just keep up with inflation but also supports a withdrawal rate in the neighborhood of 3.5-4% would be equities. Every percentage point we move to a 10-year bond or shorter-term fixed income investment will erode the prospect of making it through a 50 to 60-year retirement. It’s one of the reasons why I’m still pretty optimistic about stocks and why I dislike bonds so much. With bonds, you trade lower short-term volatility for a higher probability of running out of money in the long-term!

Inflation hedging over an intermediate (~10-year) horizon

SRR Table03
From the SWR Series, Part 15: Linear regression of the safe withdrawal rate on portfolio returns. The near-term returns matter much more than the average 30-year return! Note: Due to overlapping windows, the t-stats are Newey-West heteroskedasticity-adjusted.

In the long-run, we’re all dead, as some old (and already dead) economist once said. So, protecting our portfolio from the forces of macroeconomic shocks over shorter horizons should still be a high priority! Think sequence of return risk, i.e., the fact that low returns during first 5-10 years in retirement can sink a retirement plan even though the longer-term average return looked really good. And returns over 5 to10-year windows will look wildly different from the long-term averages. In other words, what the table with the average real returns above ignores is that returns were not a straight line up for those asset classes. In the cumulative return chart, I already included a “trend line” for each return series. For the math geeks, I construct this via a Hodrick-Prescott Filter to generate a trend series that “hugs” the raw data series over the duration of roughly a business cycle, i.e., about 6-10 years. And two fun facts: Ed Prescott taught me macroeconomics when I studied in Minnesota. And he won the Econ Nobel Prize in 2004! In any case, the trend lines for the cumulative returns aren’t straight lines, see chart below:

InflationSeriesPart4 Chart02
HP-Filter trends of the different return series. They are not straight lines! Trend returns over intermediate horizons (~10 years) vary wildly over time!

Let’s look at the annualized growth rates of those trend series and also include the annualized inflation trend (constructed the same way; HP-Filter), see chart below:

  • Long-lasting inflation shocks, those that last for a roughly a whole business cycle, are rare and normally the result of a large external shock: The two World Wars and the 1970s-80s oil shocks.
  • Nominal assets (bonds and cash) always perform poorly during those times. That’s expected: inflation erodes the value of nominal assets and the inflation shock causes a rise in interest rates. That implies a drop in the bond price even in nominal terms!
  • During WW1, all four asset classes performed very poorly.
  • During WW2, equities actually performed really well due to the bounce back from the Great Depression, while the other three performed poorly. Including gold!
  • During the oil shocks, only Gold performed well, while bonds, cash and equities had some their worst trend growth rates.
InflationSeriesPart4 Chart04
Inflation trends vs. Return Trends.

In other words, hedging against these kinds of multi-year inflation shocks will be hard in practice. Simply because we don’t know what’s the exact nature of that external shock! The only certainty we have is that nominal bonds will get hammered by inflation. It’s between hard and impossible to pin down what exact asset class will do well in that next big inflation shock.

One little side note on the chart above: One redeeming feature of the gold return pattern is that the trend returns are almost an exact mirror image of equity trend returns, at least after WW1. So, forget about how well gold hedges inflation. It tends to hedge equity performance, in that it performs really well when equities suffer (Great Depression, 1970s/80s, Global Financial Crisis). Something one would miss by looking at only the monthly correlations. There is no guarantee that this pattern will prevail, of course. But in the past, a little bit of gold exposure (maybe around 5%) would have done well in my Safe Withdrawal Rate calculations!

Hedging inflation over shorter horizons

Great news! I don’t have to reinvent the wheel because some smart folks have already done all the heavy lifting on this one. I found this pretty cool research on Unexpected Inflation Hedging. Heck, one of the authors actually shares my first name, so this better be really good!

The authors first make the point that what matters for asset returns is not so much inflation but rather the surprise or what they call “unexpected inflation.” For example, 5% realized inflation might be really bad for your bond portfolio if 2% were expected. But 5% inflation might be really good for bonds if 8% were expected (and priced into bond yield beforehand) and then inflation surprised significantly on the downside. It’s a subtle difference, see chart below, but it’s the correct and proper way of doing this exercise.

UIbeta Chart01
Constructing the “Unexpected Inflation” Series. The 1970s, early 80s had two major inflation surprises!

In any case, the authors now correlate different asset returns over 12-month windows with the unexpected inflation (UI) readings over the same window. Specifically, they estimate UI betas, i.e., a slope parameter to gauge how much over/underperformance is coming from a 1% inflation surprise, all else equal. See results below. The broad bond and equity indexes have negative UI betas, meaning that if inflation surprises on the upside then, all else equal, stocks and bonds underperform. Actually, the S&P500 UI beta (not reported in the chart below) would have been around -2, which is even a bit more negative than the MSCI World index. So, even though equities hedge against inflation in the very long term, there is likely a negative short-term impact due to uncertainty about how aggressive the central bank will be in addressing the inflation shock.

UIbeta Chart02
Broad stocks and bonds investments have negative “betas” with respect to unexpected inflation.To hedge this risk against positive inflation surprises we’d have to gain exposure to some more “exotic” asset classes!

So, in other words, a portfolio with just the broad equity and bond indexes, say 60/40 or 80/20 will still have a substantially negative UI beta (regression slopes aggregate linearly when mixing and matching asset classes, so a 60/40portfolio would have 0.6x the equity and 0.4x the bond UI beta). The way the UI betas were constructed, one would need a portfolio UI beta of +1.0 to be immune in real terms. Thus, if our portfolio has a UI beta of -2, then for every 1% of an inflation surprise, we would lose 3% of purchasing power!

Commodities (energy, precious metals, industrial metals) would have generated quite impressive positive UI betas. But in order to make a difference in the overall portfolio UI beta, we’d need a pretty substantial portfolio weight. But that comes at a price! Commodities don’t create a meaningful average return over the long run. Gold, oil, copper and aluminum and the like don’t multiply, so they don’t create any dividends and only measly capital gains. So, in order to hedge against inflation, we’d have to sacrifice some expected return! How about some of the commodity-linked equity sectors? They do have equity-like returns but also tend to have much higher volatility than the broad market index.

So, to illustrate some of the tradeoffs I outlined above, the authors of the study come up with a pretty ingenious methodology: simply draw an efficient frontier in 3D (!) instead of the usual two dimensions, i.e., add an inflation risk dimension, where inflation risk is measured as (-1)-times the portfolio UI-beta, see chart below:

UIbeta Chart03
An efficient frontier in 3D: Adding a third dimension; (-1)x UI beta as a measure of inflation risk.

Of course, we can always bring this 3D efficient frontier back to 2 dimensions. For example, we could specify a risk target of, say, 10% and then slice through the surface, see below:

UIbeta Chart04
If we slice through the 3D efficient frontier at some designated risk target, e.g., 10% then we get back to a 2D efficient frontier to illustrate the tradeoff between expected return and inflation risk!

And the line along that cut now becomes a new efficient frontier to illustrate the tradeoff between expected returns (y-axis) and inflation risk (x-axis), see below. And again, this looks like a real efficient frontier, i.e., an investor has to sacrifice some of the expected return to reduce inflation risk (=increase the UI beta):

UIbeta Chart05
There is a cost of hedging against short-term inflation: Likely lower expected returns!


Hedging against inflation is no easy task. It all depends on the horizon! Over the very long-term, equities are an extremely powerful inflation hedge. Makes sense because over long horizons, corporations have the power to raise prices and raise their corporate profits pretty much exactly in line with inflation. Over shorter horizons, commodities or commodity-linked equity seem like a great inflation hedge. But they both have drawbacks. Commodities have low expected returns and commodity-linked equities tend to have higher volatilities than the broad index.

What would I do personally? I am happy with the fact that equities keep up with inflation over the very long-term. The opportunity costs of low long-term returns make commodity investments very unappealing, not to mention the high expense ratios in some of the ETFs. But I’m also concerned about a potential future recession that may look less like 2008/9 and more like the 1970s; equities and bonds go down, i.e., bonds don’t provide any diversification. I am probably going to increase our real estate investments going forward. That would include buying a primary residence again (yes, we do consider a home an investment – it hedges housing inflation). But we also plan to move more money into our multi-family private equity funds. Similar to the REITs, rental properties tend to have positive UI betas. And they have decent expected returns and relatively low volatility. But that’s a topic for a future post in this series! Stay tuned!

We hope you enjoyed today’s post! Please leave your comments and suggestions below!

63 thoughts on “Inflation Risk for Early Retirees – Part 4: Hedging

  1. Information overload… Great post,though. How come you didn’t include real estate in the graphs? That info is probably harder to get. I’m just curious how it compare because you’re going to invest more money there.
    I think you’re right about equities and bond both going down. However, bond will still be much less volatile than stock. Even if they both drops, bond should drop much less, right?
    Gold might be a good place to hide for a while. The long term return is dismal, though.

    1. Thanks, Joe! True, this was a lot of information packed into one post.:)
      I didn’t have long-term return charts for Real Estate. But you’re right, the inflation-hedging ability of RE is an important topic so we will talk about that in a future post. Thanks for stopping by!

  2. Real estate had by far been our best return (and as such, hedge against inflation), but it can also be pretty volatile if you don’t know what you’re doing / get really unlucky. As tempting as it is to sometimes want to protect your cash from the big dips, that means you also aren’t protected against the long term upswing of inflation.

  3. Karsten, What’s your your opinion about the REIT index funds like VGSLX for the long term? Or did you mean it’s better to buy individual REIT stocks for hedging. I don’t know whether REIT’s have the same scenario as bonds. Quite a few people people swear that it’s better to buy individual bonds vs. bond funds…is it the same case with REITs if I don’t wish to be a landlord myself?


    1. I think direct Real Estate investments (owned by you or through a Private Equity fund) are likely much better than REITs: Tax advantages & better yields. But for small investments, you likely have no choice but go with REITs.

  4. Hallo Karsten,

    how do you feel about foreign currency as a inflation hege? Shouldn’t a higher inflation come along with a weak dollar? If so foreign based assets would be a vital hedge.

    1. Great question!
      Over the very long term, currencies with higher inflation will likely depreciate. But this “purchasing power parity” process is very slow and unreliable. Also, it depends on what you hold in the foreign currency. You obviously don’t want to buy Euros and Yens and Aussie Dollar bills and stick them under your mattress. In the end, you’ll hold foreign currency assets. Fixed income will again be eroded by inflation abroad.
      Also, keep in mind that the FX investments only hedge against US inflation rates higher than abroad. If the entire global economy suffers a synchronized inflation shock you’ll lose purchasing power with your foreign assets as well! 🙂

  5. Have you ever looked into managed futures (time-series momentum based)? They seem to provide a lot of “crisis alpha” during the times like the 1970s stagflation. AQR has a great paper on it (A Century of Evidence on Trend-Following Investing).

    1. In the past, momentum has worked quite well. But: My rule of thumb is that if AQR writes about some investment style the excess returns will soon be arbitraged away. Momentum will likely work again during the next crisis but there will be too many false alarms before then where investors will be whipsawed and that might undo all the advantage from avoiding the next crisis.

  6. Loving all the info you provide!. Cant wait to read your next post on real estate as a hedge for inflation. Keep up the good work!

  7. I always enjoy your provocative discussion.

    I mix some strategies for some diversified inflation protection plus some overall portfolio diversity. Presently I own some LTips, Gold, short duration debt (RMPLX) ,REITS and foreign bonds. Only a little bit of each, about 10% of my portfolio but from what I’ve as a combination these should be effective to a high percentage as a hedge against inflation. Of course I also own a lot of equities.

    I’m 1 year into retirement in a total passive environment (no side gigs) so inflation now would be killer to my portfolio longevity. My other hedges are a low initial WR (just over 2%) so I can withstand some WR inflation and I pre-funded 4 years of Roth conversion and I have tax loss harvested to mitigate some tax risk with RMD and SS at age 70. Roth conversion has its own built in SORR but when I looked at what happens to taxes when you go from married to single (as in when a spouse dies) I think it’s worth the risk to clean out 1/2 to 2/3 of the IRA. So having the freedom to marginally control how the portfolio is deflated by having a low WR and variable accounts from which to draw like IRA, SS, Roth and post tax, gives you some control over taxes are some other ways to build in some inflation protection. If we get stagflation things become more dire. I’m kind of into looking at retirement as a series of epochs as opposed to a single grand scheme. How I’m positioned now, won’t be the same as my position after for example Roth conversion or RMD or 15 years in.

    1. Yes, thanks for sharing! Great point about the tax consequences if one spouse dies.
      One word of caution: having 10% of the inflation-sensitive assets will likely not move the needle very much in the UI beta exercise as the paper from Mellon pointed out.
      Thanks for stopping by!

  8. Very impressive post. I have been wondering how our portfolio would stack up against inflation. We currently hold VFIAX and VBTLX in one portfolio, and FUSVX in another portfolio. We also keep some cash on the sidelines as well. I am still intimidated by REITs because I believe they can be a risky investment. We know someone who lost 800K and regretted heavily their decision to invest in one.

    Keep up the great work!

    1. Again, long-term you should be good. S&P500 will Hedge against inflation. But short-term there is a concern if the best recession is, say, induced by inflation and a Fed overreaction, sinking both stocks and bonds. Real estate.would be a better hedge. But I also share your concern about REITs. They seem expensive now and volatile. A direct RE investment might be better.

  9. I was scratching my head and wondering what to do for Part 5, but now I think I’ll do a Dummies Guide to Part 4! Heh heh, great stuff!

    I particularly like how you split out the longer term real returns from the impact of shorter term ‘unexpected inflation’. I’ve always thought there must be a difference, but never been able to articulate it. The notion of a UI Beta then makes perfect sense and is a powerful way to think about hedging over shorter periods. I’m impressed at the UI beta of commodities and energy related instruments, and not that surprised at the poor UI beta of MSCI ACWI.

    The bit that I’m missing here is how much should I care about UI? Whether I am early in the accumulation phase and aspiring to early retire, or entering the spendown phase, is it sufficient just to power through inflationary periods with long term real returns? I guess UI could contribute to SORR though. If your portfolio is heavily negative UI beta and there is another UI spike then real returns will be crushed.

    What struck me about the 70’s is the high UI. Obviously the high absolute inflation was an issue, but really what made it a lost decade was that inflation was not only high, but unexpected under your definition. So this killed the markets.

    I had started to look into gold as an inflation hedge. I might still pursue that analysis, since it seems to be a perennial obsession with FIRE enthusiasts. So I’ll see whether my work will complement this.

    Great stuff – those people at Mellon Capital seem like a smart bunch!

    1. I’ve read several articles on China and Russia creating a gold backed currency. If you’re denominated in dollars I’m not sure how you can’t own gold if that happens. It will also blow up our printing presses when it comes to debt.

    2. Haha, thanks!
      Maybe as retail investors we don’t worry as much about the 12m shocks to returns as, say, pensions funds and endowments. The target audience for the Mellon paper. But the scenario of an inflationary recession (supply shock) where the traditional stock bond diversification doesn’t work is certainly on my mind. It may never happen but it’s on my mind! Reminds me of the ChooseFI episode with Todd Tresidder and my reply (and strong agreement).

  10. What I wonder is how short term (say 1-3 year) treasuries fair during these UI periods. They theoretically have less inflation risk, so perhaps they should go down less than 10 year treasuries (or even go up as people flee long term to short term?). Perhaps using short term treasuries for the glidepath can help to hedge against both a stock market decline as well as UI. I would love to get your thoughts, ERN.

    Thanks for all of your great work!

      1. Yes, TIPS are the natural inflation protection. But TIPS also didn’t perform that well during the 2008/9 recession, so they had less diversification benefit. There’s no free lunch!

        PS: tried the link: it didn’t work. Please let me know if you find an updated url. Thanks 🙂

    1. Great question! Shorter-term bonds will still suffer from erosion of purchasing power. But they’ll have a lower duration and hurt less from a rise interest rates.
      Thanks for stopping by!

  11. Thanks for the great post. You don’t mention how certificates of deposits would hold up in the short term (say 5 to 7 years) during these UI periods. I’m talking about top national CD rates that I follow on the blog; not the average CD paying 0.5%. Many CDs are available with mild early withdrawal penalties. Seems they would avoid the negatives of treasuries declining values during rising inflation periods, pay higher interest rates than cash, and can be cashed in and reinvested in higher paying CDs as interest rates rise. But would CD rates rise enough to keep pace with inflation? Would banks change the terms and make the early withdrawal penalties more severe? Many people retiring in their middle 50s build CD ladders as a bridge to social security so this is an important question if UI appears.

    Update by ERN: This is a nice site! It lists the various CD providers with the highest rates (better deals than on and also those with competitive early withdrawal penalties. Updated every two weeks!!!

    1. With a light early withdrawal penalty you’d certainly avoid the duration impact of a 10-year Treasury bond. I will definitely check out that site! But the erosion of purchasing power would still hit you when a surprise inflation shock occurs.

  12. Early retirees are already experiencing hyperinflation…in Health care. Everything else pales by comparison.
    Remember tax brackets and Social Security go up with inflation.
    A fixed rate, long term mortgage is a good inflation hedge for at least some of your housing costs.
    If gasoline prices rise, I will drive less.
    If food prices rise, i will eat less meat or whatever is inflated.
    The boogeyman of “inflation” is experienced in different ways by different people.

    1. True, the mortgage hedges inflation (short nominal bonds), but the mortgage payments have to come from somewhere. If the mortgage payment causes you liquidate equities during the downturn then you don’t have much of an inflation hedge. As I wrote in the SWR series Part 21, I’d prefer not to have a mortgage in retirement.

  13. Interesting post. I am old enough to remember the high inflation of the 70s. (Too young to remember WWI or II.) My parents had purchased a house for $35k in 1971 and it rapidly inflated to $135000. They began buying CDs and MMF paying 16%. My Dad had a government job with a cola. I can remember waiting in long lines to buy gasoline. So I guess this does illustrate the real estate does well with inflation. The mind set becomes I better buy it now (iPhone X) because it will be more expensive next month. I do think that another “oil shock” is unlikely now because of fracking. Random thoughts I know.

    1. Good points! I like real estate exactly for that reason!
      Agree with the oil shocks: OPEC has no more power. In the U.S. we are now the marginal producer than can both go online and offline very quickly.
      But inflation can still become a headache even without OPEC. Healthcare, a Federal Reserve behind the curve, built-up monetary stimulus that could come and haunt us, etc. Whatever the cause, housing will likely be a good investment.

  14. I had to chuckle when I found out that you and Actuary on FIRE are doing a series on inflation risk, because I am mid-way through my own series of posts on stocks as an inflation hedge. I think if I had just started a little later, you two could have saved me a whole lot of work (and potentially rework on the last post in my series now.) I’m going to digest this some more, but a couple of initial thoughts.

    One, I looked at correlations between annual nominal and real stock returns and annual inflation using Shiller’s data going back to 1871. I found a slight negative correlation between real returns and inflation. (You can see the details in my last post.) Interestingly, I found no correlation between nominal stock returns and annual inflation. It turns out that a lot of these studies, including the one you cite here from Mellon Capital, are comparing real returns to inflation. I’m certainly no expert in finance. But as a scientist, I find this approach puzzling, because inflation appears in both dependent and independent variables. (That’s a “no no” in science, unless you control for this double counting in the correlation.) I did a little analysis in my last post using random returns and random inflation and found that you can force a strong negative correlation between random returns and inflation just by using real returns in the correlation. That makes me skeptical of a lot of this work correlating real returns to inflation. Perhaps, I’m missing something fundamental that’s obvious to you folks with finance degrees. But if you look at nominal stock returns, they provide a pretty random looking response to inflation over history. That’s clearly not a perfect short-term hedge, but it also means that in nominal terms, high inflation does not necessarily guarantee bad stock returns. That’s why I’ve been calling stocks a “sporadic” or “imperfect” hedge (short term hedge using your terminology here) against inflation in my posts.

    Two, I am pretty mystified by the expected versus unexpected inflation approach. I looked at a number of papers that parse out these two types of inflation for correlation analyses. I don’t feel like I’m fully understanding it yet, but I worry it’s easier in theory to distinguish expected from unexpected using historical data than it is to distinguish one from the other in real time using current or recent data. So, I’m skeptical of the utility of this approach. There also seems to be at least a few different ways to calculate unexpected inflation, which begs the question, how much do the betas vary using these different approaches. I found one paper ( where they calculate these betas for many time periods and countries. They conclude there is a strong negative correlation between stock returns and inflation, but my review of their graphs and tables suggests the betas vary widely and the correlation is not as consistent as they imply. As a result, I’m probably not going to attempt any of my own analyses using unexpected inflation, but any words of wisdom on this whole issue would be appreciated.

    Regardless of all that, I agree with your overall conclusion that I prefer stocks to most asset classes because of their combined ability to provide superior long-term returns along with some erratic and inconsistent inflation hedging. So, none of this really changes my investing plans, but I had to consider it. Thanks for all your extremely useful work here (and sorry for the long comment). Also, let me know if you find any of the stuff in my posts on inflation useful, or find any glaring errors in there.

    1. I care about real returns. That’s what calculates how much I can actually eat. I don’t care about zeros printed on paper money. Nominal returns are absolutely meaningless. Imagine you get nominal returns or 20% three years in a row and inflation was 0%, 20% and 40%. You would say that inflation has no impact on (nominal) returns because the correlation is zero. True, but i care about my purchasing power and my purchasing power has a correlation of -1 with inflation in this example.

      About your point that inflation appears in both the dependent and independent variable: It’s the other way around: You are the one that lets inflation creep back into the dependent variable through:
      Nominal return = real return + inflation = intercept + beta x inflation
      It all depends on the reference point.
      But just to be sure: you can estimate regression coeffficients either way (they will differ by exactly 1.0) and as a data scientist I can assure you it’s not a “no-no” to have inflation on both the left and the right side of the regression “=”

      Not sure why it’s difficult to distinguish expected vs. unexpected inflation. Unexpected = realized minus what was expected.
      It’s a general concept in finance and economics that what counts is not so much the absolute value but the value relative to what was expected. If a corporation releases earnings what do you think will correlate more with the stock price movement: the absolute earnings number of earnings number minus what was expected?

      1. The equation in your response was very helpful. It led me to read a bit more about the calculation of inflation betas. I see now that the Mellon Capital calculation is looking at the relationship between inflation and nominal (not real) returns. Their report first talks about real returns and then doesn’t mention (that I could find) whether they are using nominal or real returns in the calculation of inflation beta. Nor do they describe how inflation beta was calculated (i.e., no equation). That was the source of my confusion.

        In addition to your reply, I found this useful statement at the link shown below, where they conduct a very similar calculation: “Beta is a measure of the responsiveness to inflation of an asset class’s nominal (before-inflation) returns, incorporating its directional relationship with inflation (correlation) and the magnitude of its moves relative to inflation (volatility). Put simply, when inflation rises by 1 percentage point, an asset with an inflation beta of 1.0 will see its nominal return rise by 1 percentage point as well.” ( So, I think my concern about the use of real returns by Mellon Capital was misdirected.

        I stand by my statement that one should be careful about having the same values as components of both the independent and dependent variable (at least in a simple regression). But your right that it’s not impossible. Perhaps, “no-no” was too strong of a statement. I’m not the only one to point out this issue. I have previously posted about this report by Credit Suisse, who were working with Elroy Dimson, Paul Marsh, and Mike Staunton:

        They say there: “We are estimating a relationship between real returns and inflation. Inflation therefore appears in the regression both as an independent variable and (indirectly) as a component of the dependent variable. This can reduce the magnitude of the estimated coefficients, so the partial hedge indicated by the first row of Table 1 [their results table] may understate the hedging ability of the assets in Table 1.” I’m unclear why they didn’t do it on a nominal basis like these other papers.

        Thanks for clarifying the methodology.

  15. Hello Karsten,

    I see that you options trade. Thus you have respect for skills based investing. I am looking into information offered by Ed Easterling and Meb Faber with their research about absolute return approach and trend following with SMA200. I am not sure if you have already addressed that.

    After reading their information, I am hesitant to leg in more of my funds into the equities market knowing that I will likely have a lower return due to the high valuation.

    In terms of hedging, I buy local fully paid off real estate which I rent out when I need to. Since I have no great insights with investments, I tend to allocate a portion into various asset classes. I ascribe to the better lucky than good philosophy to an extent.

    1. Thanks!I haven’t posted anything on the momentum signal yet. But it’s on my to-do list!
      Nice job on the RE investing! I view that as the best of all worlds: decent returns + inflation-adjusted income!

    1. It’s a trade-off. You will be better protected from rising rates. But if the economy tanks and with it the stock market you don’t get the same diversification potential as with IEF or TLT.

  16. Two questions:

    What about an inflation adjusted annuity? And I’m curious about your thoughts on annuities in general. Have you devoted any posts to same?

    Also, am I the only FIREee that believes inflation is always WAY overstated? In my four plus decades of living I believe the overall price of life has barely increased. Some of my beliefs are supported by concepts such as these:

    But I also think that technological advances essentially negate much of so-called inflation. Some of this is included in the foregoing article, but we are getting a lot more bang for our buck on many goods nowadays (cars, houses, phones, etc)(and some devices such a small smartphones negate the need for dozens of other purchases), goods quality and longevity has increased, actual prices for many goods has decreased (computers, long distance calling, tvs, travel, machines, media, etc), the ability to utilize coupons, price/travel hacking, price comparison/competition leverage, etc. via the internet has vastly increased consumer power, more ideal used goods can be easily obtained via Craigslist, eBay and the like (i.e. it used to be much more challenging to find a good quality needed item), geo arbitrage has become much easier, cheap public transportation has gotten more ubiquitous, office space, work clothing and commuting expenses have become much less common and necessary, virtual assistants and other employment overhead lower, investing itself has become far better and less costly and even health care costs have dropped dramatically for many (due to a ACA my post-early retirement costs dropped by 80%) and on and on and on.

    Consequently, I think inflation (with the exception of housing and food, both of which are more than negated by the aforementioned) is wildly overstated. I expect my annual spending to increase virtually zero in the future while my lifestyle will remain the same or better based on what I just mentioned.

    So I just don’t understand the basis for ridiculous real life inflation rates anything close to even 1% a year. I would even argue that at least for the frugal and savvy FIRE crowd, the overall cost “to live” is more likely to decrease than increase, while creature comforts and luxuries will continue to improve.

    Anyone else agree with me?

    1. Careful. Despite lots of people claiming the opposite, quality adjustments are indeed factored into the CPI:
      This is indeed a reason your expenses may increase faster than in the CPI. That’s because if my computer made in 2017 breaks down I probably won’t buy that same model at a vastly discounted price, but rather a 2019 model at roughly the same price or maybe slightly lower. The CPI will price that old computer at a 90% discount.
      But you’re right about the subsitution effect. The PCE price index which measures the actual consumption will factor in substitution effects. The rule of thumb is that the PCE is about 0.2 to 0.3 percentage points lower than the CPI. This is over very long horizons and also making some adjustments due to diffferent weights in the PCE vs. CPI.
      So, long story short, there are people on both sides: CPI is wildly overstaed vs. CPI is wildly underestimated. I will stick with the middle and assume CPI is the “right” adjustment. But I agree that there’es about 0.5% uncertainty in either direction.

      1. But are quality improvements factored into CPI; for example, tires that last thousands of miles longer than those of not so long ago, cars in general that last longer (still drive my 2003 Honda Accord – runs great)? And the behind-the-scenes substitution effects; for example, Google Lens on a cheap smartphone translates signs, saving the need for human translators. GPS in my phone obviates the need for the old Garmin systems, let alone the printed AAA maps. I can’t help but think that these sorts of quality improvements and substitution effects are very difficult to capture in and index

        The relevance of this is that, when deciding upon asset allocations, how much return is good enough? I have access to an annuity that has no surrender fee or withdrawal/rollover restrictions at retirement (in my wife’s 403b plan); it pays 3.1% guaranteed. These inflation measurement uncertainties make decisions such as this very tough. If inflation is overstated, this would be a compelling de-risking of a portion of our assets.

        Thanks for all you do for our community, Big Ern. Your blog is a great source for educating myself on various topic; I love to dig though past articles for thought provoking info.


        – Eric

        1. I can’t speak for the BLS on any specific products. Not all quality improvement will be captured.
          Just as a guide, how much lower do you think your true CPI would be thanks to the uncaptured quality improvements?
          Also, if you want to play around with paths that adjust spending with CPI-x% or CPI+x% that’s all doable with my Google Sheet. So if you think that your personal CPI is 0.5% lower than the quoted CPI you can play around with that easily! 🙂

  17. Re the “unexpected inflation” idea. Seems to me it’s essentially impossible to make decisions in advance about this, and it also seems hard to get historical monthly data on it (if you have a source, that’d be much appreciated).

    FWIW in seeking to create a market timing (a.k.a. Tactical asset allocation) method across bonds and gold, I found that the year over year rate of change of inflation mattered historically a lot more than the level of inflation in terms of whether bonds or gold would do better going forward.

    In other words, bonds do better when there has been meaningful disinflation the prior 12 months, while gold does better when there has been a meaningful increase in the inflation rate vs a year ago.

    1. You need the historical inflation expectations. SPF (Survey of Professional Forecasters) has very nice historical data, I believe going back to the 1960s. It’s only quarterly, but usable.
      Starting in the 80s or so, you can get monthly data from BlueChip, Bloomberg and some other providers. Back when I wrote my research I still had all that access from BNY Mellon. Now I have to rely on the free data from SPF.

      Also keep in mind that none of the inflation surprise has any direct use for tactical asset allocation. Only if you come up with a *better* inflation forecast that can front-run the big inflation surprises, would you use this as a tactical signal. In the current form, this is just a purely descriptive piece of work.

      1. In my SWR sheet hacks, I found that whether inflation is rising or falling *meaningfully* (i.e. more than a tiny amount) in the last 12 months makes a pretty good indicator of whether gold or bonds will do better. Momentum of a sort.
        I *suspect* there’s a pretty high correlation between rate of change of inflation over the prior 12 months and what inflation expectations are for the next 12 (most people most of the time expect things to continue. And they often do). The current environment being a very notable exception, of course.
        That said, I’ve not run any analysis, so this just educated conjecture. But I thought the info re rate of change of inflation, vs level of inflation, being more important to bond returns might be useful and relevant here.

        1. Makes perfect sense. The reason why momentum works in financial returns is that there is macroeconomic momentum. That’s true for inflation in particular. In fact, if anyone comes up with an inflation forecasting model, the baseline comparison model is always the naive “momentum” model 12M future inflation = 12M ast inflation. How much better than that can the more sophisticated model do?

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