Dealing with High Inflation: A Preservation Tale

Posted by Carlos Sera on Sep 10, 2015 1:10:00 PM

dealing-with-high-inflationThis tale is specifically written for those that are looking for ways of dealing with high inflation with a secondary consideration for dealing with high inflation and receiving periodic income from your portfolio.  It is why I call it A Preservation Tale, because the objective during periods of high inflation is to preserve purchasing power.  It is not to stay ahead of the game but to not fall too far behind.  However, this tale is also useful for anyone that is looking for the types of assets to include in your portfolio.

I was fortunate to have met and been mentored by some wise and veteran brokers at Legg Mason back in the late 1980s.  This was in the days when the firm emphasized value investing and the retail or individual investor.  Back then, their expertise was managing money for people and not institutions.  These veteran brokers had no schooling in Modern Portfolio Theory, Market Efficiency or the Capital Asset Pricing Model. They probably couldn’t even tell you what a standard deviation or correlation coefficient was.  But they understood investor behavior and knew how to apply it and make it work for people.  They understood that the essence of why a person came to see them is so they wouldn’t die broke.  Their “old school” core beliefs and their approach to managing money were nothing like what most people see today.  But in my opinion they were more right about managing money than today’s advisors and their core money management beliefs still make up a large part of my core money management beliefs.

These veteran brokers had just recently lived through a 10 year period of the highest US inflation over the last century and were very cognizant of the damages to a portfolio that wasn’t protected.  Everything they did they did with an eye towards inflation.  It is for this reason they over-weighted client portfolio with stocks since it was the belief at the time that this was the best way to preserve purchasing power.  Almost 25 years later, I still see the wisdom and elegance of their approach and will provide you with an “old school” solution at the end of this tale.

Walk into an advisor’s office these days and they will try to sell you on at least one of three things.  They will try to sell you some type of insurance, their asset allocation model or their promised close and personal relationship.  I am not being critical.  These are important things but they are very different from what an “old school” advisor would sell.  The “old school” advisor had a laser-like focus on the preservation of capital and understood that the enemy to client success was in order of importance

1) The client’s behavior,

2) Inflation,

3) Asset Allocation and lastly

4) Asset Selection.

Their belief was that yes insurance was important and you should be adequately insured and have some estate plan in place and that yes they would maintain a relationship with the client but that the heart of the relationship was the asset allocation model and the assets selected to go into the model.  They knew insurance products or a great relationship couldn’t overcome high inflationary periods.  Furthermore, they understood that the asset allocation model had to preserve capital since capital preservation was the glue that would bind the advisor and the client through thick in thin, which translated in practice to—through thin.  If the asset allocation model was too volatile they knew the client would experience an emotional rollercoaster and would ultimately bail on the strategy.  They knew the asset allocation model had to meet the needs of the client and additionally had to meet the needs of a broad universe of people.

Let’s clear up one point before we proceed further.  If your advisor says they will customize a portfolio for you, I expect you to run for the hills.  Mind you, this is different from a financial plan that is a reflection of many aspects of your life and should be accommodative.  But at the core of any financial plan is the portfolio and the portfolio is a function of the asset allocation and the asset selection.  This can’t be customized.  Would you ask Warren Buffett or George Soros to customize a portfolio just for you?  I think not.  The “old school” brokers did not believe in portfolio customization and neither do I.  You shouldn’t either.  As we’ve learned throughout these tales, most portfolio managers aren’t very good to begin with.  Those that are have spent a lifetime developing the techniques, styles and methodologies that are a reflection of their belief system, personality and ability to execute.  Yet, you want them to customize something just for you.  Forget about it.  You can customize a financial plan but not portfolio management.

So what were their core beliefs?  Once again, they had a core approach that transcended the particulars of the person.  They did not believe in personalized portfolios.  However, they weren’t stupid and understood they needed clients.  So if you asked them to create a customized portfolio or develop a personalized financial plan they understood you did not know the difference in most cases so they would give you an earnest and confident look and told you what you wanted to hear.  Being the consummate salesmen, they would personalize a portfolio just for you.  But in reality, it was the same basic solution they had for everyone with very minor modifications.  My favorite of the bunch would say, “When you go to the doctor and they prescribe antibiotics you take them and get better.  It’s almost always the same antibiotic prescribed to every patient.  Our job is to also prescribe the same antibiotic to every client.  Stick to what works because “personalization does not lead to prosperity.”  I have never forgotten that line and use it to this day.  So their main core belief was to have only one core belief and that was to stick with things or solutions they expected would work.

So what were the things they thought worked?  They believed in buying “value” or assets that were cheap relative to their future earnings and they particularly liked “value” stocks that did well under periods of inflation.  Remember at the time, these types of stocks were less volatile than others and these “old school” brokers gravitated towards lower volatility.  They liked established companies with pricing power that were household names and had a long history of paying increasing dividends.  They loved companies that paid high dividends generated from excess free cash flow and sold under or near book value.  Lastly, they believed in owning a diversified portfolio of stocks in different industries and stayed as far away as possible from owning commodities.  They reasoned as follows, why put money into something that doesn’t pay either interest or dividends.  They thought it silly to own oil instead of Exxon or gold instead of Barrick or to own agriculture instead of Monsanto.  As they would tell me, when commodities crash they crash just as hard as stocks, so where’s the diversification?

Conversely, what were the things they thought didn’t work?  They shunned margin accounts, derivatives, excess trading, speculation and reaching for yield.  As they would say to me on margin accounts—they are great for 17 out of every 20 years—but you need a whole new set of clients those other 3 years because they’ve gone broke.  On derivatives—which at the time meant options—they reasoned, why would you ever invest in something where you can be right and still be wrong?  On excess trading they would say—if you are a great trader, then trade your own money exclusively—there is nothing more profitable in the world.  Great traders don’t need clients or at least not many.  On speculation—we are not here to speculate with a client’s money.  That is their job not ours.  Lastly on reaching for yield—-they would say this is the portion of a client’s portfolio they want to keep safe—do you really think an extra 5 or 20 basis points matters when the stock market portion of the portfolio fluctuates this much every 5 minutes?  Keep safe money safe.

So what does this have to do with A Preservation Tale?  I thought this tale would tell me what to do to preserve my capital during high inflationary times.  I expected to read this tale and hear things like I should invest in gold, or timber or commercial real estate or treasury inflated protected securities (TIPS) or commodities or something I’ve never heard of before?  Sorry to say, I have found no evidence, other than perhaps TIPS, that convinces me a portfolio can allocate resources in a manner that protects against high inflation in a manner directly correlated to the inflation rate.  If you are looking for one I suggest you stop and focus on populating your portfolio with assets that have a history of dealing with high inflation through thick and thin even if they don’t do it on a one to one basis.

So what can you do to preserve your capital during high inflationary times?  The answer is stop asking that specific question.  It’s illogical.  If you knew when high inflationary times were coming or if I knew or if anyone knew, we would have a trading oriented portfolio approach that could adjust accordingly.  But we don’t, no one I know does and so we are left to invest in those types of assets that have historically preserved purchasing power over long periods of time without trying to pinpoint high inflationary times.  The evidence is clear and the best laboratory to test this evidence was the 10 year high inflationary period in the United States that ended in 1982.  During that period, inflation averaged almost 10% per year.

Much of what we know or think we know about dealing with high inflation is rooted in the hindsight analysis of that 10 year period.  The economic policies of the time and the discussions of the time were very different than today, just as today’s discussions will be different from tomorrows.  But what is clear is that during the 10 year period your best bet was to not let high inflation overrun your portfolio’s purchasing power.  Stocks, bonds, real estate and most commodities did not keep pace with the high inflation much less match its’ every gyration.  In hindsight, the game was to own the major asset class or classes that lost the least.  So the lesson from this tale is to develop an all season asset allocation model that at a minimum keeps pace with inflation over long periods of time and don’t try to guess when high inflationary times are upon us.  However, you better populate your portfolio or at least a large portion of your portfolio with the types of assets that preserve purchasing power or you will be sorry.

Before I give you and “old school” solution let’s destroy one myth to illustrate the difficulty of pulling off a successful inflation-beating strategy.  One of the outgrowths of the 10 year period ending in 1982 was the incorrect belief that people should borrow money at a low fixed interest rate on their house purchase and that when prices appreciated not only was your housing asset appreciating but you were paying your mortgage off with dollars that were worth less.  This strategy made sense until it didn’t as those that blindly bought houses 5 or so years ago can attest.  When houses went down in price, people ended up owing more than their house was worth and they were stuck in loans they couldn’t refinance.  If you followed this flawed strategy that worked in the high inflation times of days of yore, you are still trying to recover from your failed inflation hedge and may be trying for many more years to come.  But just like a broken clock is right twice a day, given the recent and significant decline in US housing prices and the low fixed rates of today for those that can qualify, it is certainly a much better investment or hedge against inflation today in October of 2011 than it was 5 years ago.  This means the flawed strategy will persist since it will work for some people and at some future date the last 5 years will be forgotten and looked upon as an anomaly.  People will repeat the mistakes of the recent past.  So is borrowing money at low rates to buy a house and paying it back over long periods of time a good idea?  The answer is as always—it depends on your timing.

What about the opposite?  Is it a good idea to lend money at low rates and get paid back in dollars that are worth less over a long period of time?  If you answered no then you need to avoid long term bonds as an investment at this time.  A simple analysis shows that not one time has anyone that invested in bonds at yields as low as they are today beaten the inflation rate over the next 20 or 30 years.  So, when we hear those espousing safety and predictability make sure you understand what they are saying—they are espousing a guaranteed loss of purchasing power.  Don’t be distracted and don’t be afraid.

So what might be an “old school” portfolio in today’s time?  I said at the beginning of this tale that there are a few ways to protect against dying broke.  The following solution is an old fashioned approach that has lost favor for a number of reasons that aren’t important today.  I think it is one of the better ways to not die broke as well as preserve purchasing power.  I call it the High Stock Dividend Portfolio or HSDP.

What if Mr. and Mrs. Jones went to see a competent advisor with $1 million dollars to invest and wanted $40,000 per year of income.  Furthermore, what if the advisor was an “old school” advisor and devotee of high dividend paying stocks and he suggested they invest in an HSDP.  It is quite possible today for the advisor to create a portfolio of high quality high dividend paying stocks that on average pay about a 5% yield which would provide the $40,000 per year and allow $10,000 towards reinvestment into the portfolio.  Does this sound ridiculous?  Does an all stock portfolio dependent on dividends only sound ridiculous?  Not to me it doesn’t.  Unfortunately, it sounds like a lawsuit waiting to happen however which is why it has lost favor but it is an elegant, thoughtful, though at this time, unconventional solution.

The fact is, as we can see from A Consistent Tale, a diversified portfolio of highly rated large capitalization high dividend paying stocks has been one of the surest sources of consistent cash flow known to investors.  What this means is that even if in the first year the market dropped 30%-40% the Jones would still receive their required $40,000 because the stocks would continue to pay dividends.  They would also have the $10,000 to invest in these same quality stocks that have dropped in value and are thus buying them at cheaper prices than before.  Yes their portfolio fell in price but it didn’t disrupt their lifestyle and because these companies are the cream of the crop many if not all of them will eventually recover.  However, this plan does not protect the Jones’ from the Jones’.  The reason this approach is out of favor is due to the fact that if and when there is a large drop in the stock market there is a high probability people like the Jones will panic, sell near a market bottom and hold their advisor responsible for such “lousy” advice.  The advisor’s response to this is to not recommend this type of approach.  However, most competent advisors know a thing or two.  They might allocate a portion of the Jones’ portfolio to an HSDP strategy and a portion that won’t lose as much during a severe market drop.  I know one advisor that wouldn’t have it any other way.

Another more modern solution to the problem the Jones face is to invest their portfolios in a dynamic fashion instead of or in conjunction with a static fashion.  This type of dynamic solution is a wonderful tool to include within an HSDP approach in my opinion.  It’s like having two purchasing power preservation strategies within one portfolio.  While static strategies such as HSDP will always suffer large losses when markets drop since they by definition are always invested in the stock market, dynamic strategies may or may not since they have the flexibility to avoid large market drops.  I suggest the reader refer to the February 2010 Journal of Financial Planning Feature Article: A Simple Dynamic Strategy for Portfolios Taking Withdrawals: Using a 12-Month Simple Moving Average by Michael M. Garrison, CFP®; Carlos M. Sera; and Jeffrey G. Cribbs, CFP® to see one type of dynamic strategy they may want to incorporate.

In summary, the best way to prepare for an eventuality when you have no way of knowing the timing of the eventuality is to prepare for it at all times.  Your portfolio must always protect against inflation and the lower the volatility while protecting against inflation the more likely you are to stay with that type of portfolio.

preserve-your-worth

Topics: Tales, Wealthy Tales

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