Want to Beat Inflation? Think Like an Institution

When inflation fuels market volatility, individuals should avoid knee-jerk moves and follow the time-tested habits of institutional investors.

May 11, 2022 

After decades of low interest rates and negligible inflation, investors are now confronted with a macro environment not seen in 40 years, with the Consumer Price Index growing by 8.3% in April from a year ago. Talk of recession is increasing, and the torrid pace at which prices have soared has rekindled memories of the inflationary shocks in the 1970s.

Many individuals are reacting by making wholesale shifts in their investment allocations to different asset classes. But by looking at fund flows since 2020 and real returns (after inflation), it’s clear how little value there is in jumping in and out of markets after the inflationary surge has already happened.

Instead, it pays to think and act like an institution. Institutional investors design portfolios and investment plans for the long term to withstand different market environments, and stress-test them with worse-case scenarios. They adhere to detailed Investment Policy Statements which are aligned with long-term investment goals, and also provide a guide for shorter-term tactical allocation tweaks that can take advantage of economic or market changes. The result is that their portfolios are already inflation-proofed, long before inflation became a problem.

Emotional Fund Flows

Fund flows since the pandemic illustrate how many retail investors made rash decisions during extreme bouts of volatility. Yet, in a bid to protect their portfolios from economic and market shocks of the day, many ended up in the wrong markets at the wrong time.

In the nine quarters from January 2020 through March 2022, the S&P 500 has returned 45%, while bonds have lost 0.4%. Yet equity volatility in 2020, and then fear of an equity market correction in 2021, caused investors to pour more than $1 trillion into bond funds and ETFs.

Exhibit 1: Fund Flows 

total fund flows

Besides losing the extraordinary equity returns in 2020 and 2021, those who sought the safety of bonds ended up in an asset class that is the most sensitive to rate hikes by the Fed. In fact, in the first quarter of 2022, fixed income suffered its worst performance in decades.

Of course, inflation has come in persistently higher than expected over the past year. But as equities provided a meaningful hedge against inflation, bonds suffered a 9% erosion of purchasing power. Although hindsight is 20/20, those investors who stayed the course and didn’t sell equities in years when inflation was subdued, now find their real returns comfortably ahead of inflation.

Exhibit 2: Meaningful Real Returns from Equities 

cumulative nominal and real rates

Planning and Discipline Pay Off in the Long Term

Attempting to time the market rarely works. One of the reasons why institutional investors stay the course during periods of volatility is because history shows that the worst days in equity markets are very quickly followed by the best days.

Exhibit 3 illustrates the importance of staying invested. An investor who remained fully invested in equities from the beginning of 2020 through the first quarter of 2022 realized a return of over 45%, even amid the market’s ups and downs. Missing the single best day reduced that return by nearly 13% and missing the 10 best days resulted in a loss of roughly 18%.  

Exhibit 3: Danger of Market Timing 

days in market

Moving in and out of markets also untethers portfolios from an investor’s long-term objectives. Institutions like foundations and endowments avoid this by deciding how they will respond to certain market conditions before they occur, ensuring that they act appropriately when the time comes.

BNY Mellon Wealth Management takes a similar disciplined institutional approach. Client portfolios are built to be resilient in the face of market turbulence, and while tactical changes may be made to adapt to various market environments, they are often made at the margin, and always within the framework of a plan outlined by an investment committee and documented in an Investment Policy Statement. 

A client’s asset mix is determined by their long-term goals and is built to withstand different market conditions that may play out over an entire economic cycle.

Inflation-Proofing Portfolios

Our asset allocation and investment strategies already contain various inflation hedges, so our clients don’t need to drastically reshape portfolios in hopes of offsetting the impact of rising costs.

Inflation-proofing a portfolio includes spreading equity holdings across different market capitalizations and geographies, as well as including exposure to certain diversifiers (also called alternative asset classes) which can potentially lower overall portfolio risk and increase returns. Having exposure to private equity, for example, can provide an attractive source of return and lower correlation to public markets. A broad commodity exposure and allocation to real estate can also command pricing power to offset inflation and act as a hedge to some degree.

Although fixed income bonds can help to anchor portfolios during economic downturns and periods of equity volatility, they are a poor inflation hedge. Bonds are hit on two fronts by rising inflation: the fixed stream of income they provide loses purchasing power as goods increase in price, and their principal value erodes as rates increase in response to higher inflation.

Although our client portfolios have been underweighted in fixed income for some years now, we believe it’s important to diversify bond holdings to include sectors that can perform during inflationary periods. They can include Treasury Inflation Protected Securities (TIPS), corporate floating rate loans, and absolute return strategies designed to provide an uncorrelated source of return without the interest rate sensitivity. We also keep maturities of fixed income securities very short, because the longer the maturity, the more sensitive a bond’s price is to rising rates and inflation.

Active Wealth Helps Investors Navigate All Markets

As uncomfortable as it might be to not pull out of markets when recession talk and rising rates dominate headlines, sticking to the time-tested habits of institutional investors can help you reap significantly better real returns over time, and more so than if you followed the stampeding herd.

Our approach helps investors stay focused on what they want to accomplish with their wealth over the long-term, knowing that their investment plans can successfully navigate more turbulent markets. Investors in our Fully Diversified Balanced portfolio realized a cumulative return of over 24% from 1/1/2020 through 3/31/221. By staying invested and rebalancing monthly, investors were able to navigate volatility, rising rates and higher inflation. Even after inflation of over 8%, investors reaped a real return of 16%.

Over BNY Mellon’s 237 years serving institutions and individuals, we’ve learned that overall portfolio performance is significantly enhanced in the long-term if a client’s investment plan combines strategies involving all five principal factors that affect wealth preservation and creation: investing, spending, borrowing, managing taxes and protecting assets. This Active Wealth approach ensures that a client’s wealth is being preserved and continues to grow over the longer-term, no matter what the current economic or market environment.

  • 1 BNY Mellon Wealth Management Fully Diversified Balanced model performance reflects a hypothetical model based on the asset allocation recommendations of BNY Mellon Wealth Management’s Investment Strategy Committee. The model’s objective is to maintain a consistent balance between current income, growth of principal and downside protection. The performance of the model is not composed of actual client accounts, which may be materially different from that shown here. BNY Mellon Wealth Management’s performance is calculated monthly (gross of fees, net of transaction costs within each underlying asset class used and assumes reinvestment of dividends). Past performance is no guarantee of future results.

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