As economists debate forecasts for interest rate increases — how likely? how big? how soon? — advisors looking at portfolio strategy face a more straightforward question: How have various asset classes performed during years with varying levels of inflation?

In the years since 1970, the median annual rate of inflation, as measured by the Consumer Price Index, has been 3.37%; the average rate over the past 44 years has been 4.27%. (The linkage between the federal discount rate and the Consumer Price Index is fairly distinct, with about a 70% correlation between the two since 1970.) The average is higher than the median in this case because of three particular years — 1974, 1979 and 1980 — in which inflation exceeded 12%, skewing the average upward but with virtually no impact on the median.

To understand how those varying rates have affected investments, we divided the 44-year period into two groups — the 22 years in which the annual inflation rate was below the median level of 3.37%, and the 22 years during which the annual inflation rate exceeded the median.

The Inflation by Year chart below ranks the years in order of inflation rate. You’ll note that the high inflation period is dominated by years during the 1970s and 1980s; most of the low inflation years, meanwhile, fall during the last two decades (1990s and 2000s).

Then we looked at the asset classes in two ways — gross returns and net returns. More on the latter, which factors out the impact of inflation, in a moment.


The top half of the Gross vs. Net Returns chart on page 80 shows the unadjusted returns of the different asset classes. Large-cap U.S. stocks, as represented by the S&P 500, had much better performance during periods of lower inflation (shown by the green bars). The median annual return for the S&P 500 during years of low inflation was 15.89%. When inflation was higher — that is, in the years when the inflation rate was above the median, shown by the blue bars — U.S. large-cap stocks had a median return of 6.41%.

We see the same basic pattern for U.S. small-cap stock (measured by the Russell 2000 Index) and non-U.S. developed stock (MSCI EAFE index): better performance during periods of low inflation. Bonds (as measured by the Barclays Capital Aggregate Bond index) had slightly better performance during periods of high inflation — at least when measuring performance in gross terms. Cash (defined as three-month T-bills) was clearly advantaged during times of higher inflation — again, on a gross returns basis.

The median returns for real estate (using Dow Jones U.S. Select REIT index) were essentially the same across periods of high and low inflation. The one other asset class that showed a huge differential in performance during years of high and low inflation was commodities (S&P Goldman Sachs Commodity index), where the median return was 3.25% during years with low inflation but 24.66% during years with high inflation.

We also looked at the performance during high- and low-inflation periods of two types of portfolios: a seven-asset portfolio, which used each of the asset classes in equal allocations with annual rebalancing; and a portfolio of 60% large-cap U.S. stock and 40% U.S. bonds (also rebalanced annually). Regardless of inflation rates, the broader seven-asset portfolio outperformed the 60/40 portfolio, showing the advantage of diversification. The seven-asset portfolio performed slightly better in high-inflation periods than in low inflation, whereas the 60/40 portfolio did better in low-inflation years than amid high inflation.


Yet gross returns don’t tell the whole story. It’s impossible to evaluate asset class performance without factoring in the impact of inflation on returns.

The lower half of the Gross vs. Net Returns chart (below) highlights the net performance of each asset class after subtracting out the impact of inflation. When inflation is factored into performance, every asset class — and both portfolios — had higher net returns during periods of low inflation except one: commodities.

The inflation-adjusted net performance of commodities was 18.31% during periods of high inflation — surprisingly close to the asset class’ 24.66% gross performance during periods of high inflation.
Among other asset classes, inflation-adjusted performance varied. The net performance of large- and small-cap U.S. stock is impressive when inflation is low (green bars) but dramatically lower in years when inflation was high (blue bars).

The net returns of U.S. bonds also suffered greatly when inflation was high. Notice that when inflation was high, U.S. bonds had gross returns of 7.4% but inflation-adjusted returns of only 2.18%. The real-world (net) performance of U.S. bonds obviously favors periods of low inflation and is hurt during periods of high inflation.

The inflation-adjusted performance of real estate is also better during periods of low inflation, whereas gross returns were basically the same during high and low inflation.


Among the portfolio options, the inflation-adjusted performance of the 60/40 portfolio was devastated during periods of high inflation, dropping to a median net return of 2.67% from a median gross return of 9.46%. During the more favorable periods of low inflation, the 60/40 portfolio showed a much smaller difference between gross and net performance, with an 11.86% gross return vs. a 9.37% net return.

The 60/40 portfolio is highly vulnerable to inflation because of the 40% allocation to bonds, which suffer in periods of high inflation. The inflation-adjusted performance of the seven-asset portfolio shows more downside protection in times of high inflation, largely because of the inclusion of commodities: Its median gross return of 13.68% in high inflation periods fell to a more manageable 6.66% when adjusted for inflation.

The past 20-plus years have provided generally favorable conditions for a 60/40 portfolio. Interest rates have been in decline since 1982 — witness the 6.4% average annualized return for U.S. bonds since 1991 — and inflation has averaged 2.5% since 1991. Both of these factors provided a tailwind for bonds.

Yet should inflation and interest rates both begin to rise, U.S. bonds will face a stiff headwind. It will be vitally important to build multi-asset portfolios that include diverse ingredients that are more resilient to the headwind of rising rates and inflation — such as commodities and real estate.
The venerable, but underdiversified, 60/40 portfolio is not positioned to thrive during such conditions. 

Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah, is an executive in residence in the personal financial planning program at the Woodbury School of Business at Utah Valley University. He is also the developer of the 7Twelve portfolio.

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