If you believe, as I do, that we're likely in a period of "epochal change" (which I defined as the next few decades not being like they were for the last few), we're left with the question I posed at the conclusion of my previous article: What to do?
The most important thing
Before I try to dig into some of the options and I touch on the things I've been doing practically, I want to stress a crucial truth from Matt. 6:27–34 that should guide us all:
And which of you by being anxious can add a single hour to his span of life? And why are you anxious about clothing? Consider the lilies of the field, how they grow: they neither toil nor spin, yet I tell you, even Solomon in all his glory was not arrayed like one of these. But if God so clothes the grass of the field, which today is alive and tomorrow is thrown into the oven, will he not much more clothe you, O you of little faith? Therefore do not be anxious, saying, 'What shall we eat?' or 'What shall we drink?' or 'What shall we wear?' For the Gentiles seek after all these things, and your heavenly Father knows that you need them all. But seek first the kingdom of God and his righteousness, and all these things will be added to you. Therefore do not be anxious about tomorrow, for tomorrow will be anxious for itself. Sufficient for the day is its own trouble (ESV).
We see from these verses that God has promised to care for us as we put our faith and trust in him. We're not ultimately dependent on the U.S. or world economy, its leaders or economists or central bankers, or our investments for our provision. Our Heavenly Father has promised to provide all we need as we serve him and seek his kingdom his righteousness (Matt. 6:33).
Therefore, we mustn't do anything out of fear, greed, or unbelief. Instead, the most important thing is to keep our faith and trust firmly in God and him alone to see us through the next epoch, no matter what transpires.
The next most important thing
The next most important thing is to respond wisely (which may mean not "responding" at all), not just react (or overreact).
Anything we do should be done out of faith and based on a desire to wisely steward the resources God has entrusted to us by following what he has told us in his Word.
Reacting out of fear, greed, or confusion will likely lead to bad outcomes—worse than doing nothing.
But, if you believe that the future may not be the same as the past in terms of the economic forces at play, especially tightening fiscal and monetary policy versus a very "loose" environment for the last two decades, then it may be wise do some things differently than you've done in the past.
If you have a well-diversified portfolio and are working with a trusted advisor to adapt as market and economic conditions change, you may not need to do anything more than that.
If not, you may want to start focusing less on investments that did well before 2022 (growth stocks, especially tech stocks, and bonds) and shift some money toward other assets, such as inflation hedges and value stocks.
You may think there's a "secret sauce." When it comes to stewarding our resources during new or different economic conditions, the only secret is that there is no secret.
As you will see, my suggestions for things you could consider are not new. There are tried and true ways of dealing with the effects of inflation, rising interest rates, and stagflation (inflation with slow economic growth).
And they involve more than just looking at alternative investments. It's best to take a holistic view of your finances.
Here are a few suggestions to consider. They could apply to you whether you are in the "accumulation" (pre-retirement) or "decumulation" (in retirement) stage of life.
1. Do Nothing
Perhaps you've heard the phrase, "don't just do something, sit there." Well, that's what this option is about.
Doing nothing—which can mean continuing what you're already doing—may well be the best thing you can do, no matter how uncomfortable the recent losses to both your stocks and bonds have made you feel.
Deliberately doing nothing other than what you're already doing is doing something if you believe you're already well-positioned for the changes that are here and that lie ahead.
If you have a well-diversified portfolio that aligns with your risk tolerance and, for current retirees, a cash bucket you can draw from during a prolonged down market, you may want to stay the course.
If you're in the accumulation stage and have been investing in stocks, it may make sense to continue to do so. Dollar-cost-averaging during down markets can pay off big later on when the stock market comes back, which it inevitably does.
Or, you may want to "tweak" your portfolio based on option #6 below. That's what I've been doing, albeit very slowly and ever so slightly, but it may not be necessary depending on how you view the changes taking place and your current asset mix.
2. Reduce your expenses and adjust retirement account withdrawals if you need to
Higher inflation and falling markets can translate into less income in retirement. Plus, whatever income you have will buy less. Therefore, some may need to consider lifestyle changes to cope with rising prices.
Perhaps you are withdrawing 4% annually from your retirement savings (the so-called "safe withdrawal rate.") See if you can reduce your spending, so you only have to withdraw 3% or less.
Try to spend from your cash bucket to avoid selling depreciated assets.
3. Pay off any variable interest rate loans you can
If the Fed follows through with raising interest rates as quickly as suggested, those with adjustable interest rate products (credit cards, for example) can expect their rates to rise. (Some already have.)
Just as you want to borrow at fixed interest rates during times of rising inflation and interest rates, you may wish to avoid rate increases to any adjustable-rate loans you have by converting to a fixed rate if you can.
4. Consider not adding to your bond funds right now
Bonds are an important diversifier in stock-oriented portfolios and a source of income for those in retirement.
But if you're in the accumulation phase (pre-retirement), you may not want to continue to contribute to bond funds right now. If you do, you effectively lend money (to governments or corporations) at fixed interest rates while rates are rising.
On the other hand, if you do invest more in bond funds, you are doing so at a discount. But as we know, as interest rates and bond yields rise, the price of your existing bonds goes down. So be prepared for more losses as the Fed increases interest rates.
There is a silver lining: your existing bond funds will invest in newer bonds with higher yields. Consequently, interest payouts will rise, which is positive for income-seekers.
Still, those who don't need the income may be better off restraining their allocation to bonds until interest rates and bond prices stabilize.
One alternative is to keep the money in cash (money market, T-bills, or CDs), which can outperform bonds when inflation rises and bond prices fall. But remember, the purchasing power of any cash or cash-like asset you hold will be reduced by the amount of inflation (which translates into –8.5% right now).
If that gives you pause about holding too much cash, it should.
5. Use an income-focused strategy
Investing mainly for income is a common strategy used by retirees. Most retirees are more focused on income—their "retirement paycheck"—than capital appreciation, which was more of a priority before they retired.
It's possible to invest in ETFs (Exchange-Traded Funds) and CEFs (Closed-End Funds) to maximize income, perhaps in the 4%, 6%, and even 8% to 10% range, with less emphasis on growth.
A high-income strategy uses stock funds with covered call options to boost income and high-yield (and sometimes leveraged) fixed-income instruments to construct high-income portfolios.
This strategy is appealing. It's become more popular after years of historically low interest rates. But it's also riskier than a traditional dividend stocks and bonds portfolio.
I've used a more conservative version of this strategy by investing in dividend or interest-paying stock and bond funds (mostly ETFs) to generate income in the 2% to 4% range. My goal is "income with capital preservation and some growth."
I still like that strategy as I'm not too fond of the idea of selling assets to fund my retirement. Even so, while I'm not going to abandon my income-oriented strategy totally, I think the epochal change we are in suggests my need of a slightly more diversified growth and income strategy, perhaps with less capital perservation.
If you're already a conservative income investor, you may want to stay the course. But be prepared to adjust your growth and income expectations in the years ahead. I'm shifting slightly toward more of a hybrid "income plus growth" approach, but I will still put most of my focus on income; there's something to be said for collecting that "regular paycheck" no matter what asset prices are doing.
If you are comfortable with a high-income portfolio and the volatility that comes with it, then it may be a viable option for you. Just be aware that you will experience a LOT of gut-wrenching ups and downs even if your income stays pretty stable.
I'm sticking with my more conservative approach with some modifications. (More on that in the next section.)
6. Diversify your portfolio to cope with changing economic conditions
Other than reducing spending, the most important thing to think about is probably to have a reasonable diversification strategy, which in this case, might include assets that may hedge against stubbornly high or long-term inflation and higher interest rates.
Diversification is a common and prudent way of investing, and in many ways, not having all your eggs in one (e.g., stocks) or two (e.g., stocks and bonds) baskets is just plain common sense.
The idea behind greater diversification is simple: If one egg breaks, you have others. The more diversified you are, the less likely they'll break unless you drop the whole basket. Hopefully, that won't happen (though it could).
In Ecclesiastes 11:2, King Solomon (we think) tells us something about diversification:
Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.
I read a book a few years ago by Brigham Young University professor Dr. Craig L. Israelsen titled 7Twelve: A Diversified Investment Portfolio with a Plan. (I also quoted him a few times in my Redeeming Retirement book.) In it, he discusses a study that he undertook to look at investment returns for portfolios with various asset mixes from one asset (all cash), two-asset portfolios (cash and bonds), three-asset portfolios (cash, bonds, and large U.S. stocks), etc., up to seven-asset class portfolios.
He also studied a total of ten possible portfolio combinations.
He found that the portfolio with the highest return with the lowest amount of risk over a thirty-seven-year period (which provided an average yield of 11.25% per year) included all seven assets. In other words, the most diversified portfolio had the highest return with the least risk (versus the others).
Although Dr. Israelsen makes some recommendations, Solomon didn't specify which asset classes to diversify in. We have to sort that out ourselves. However, here is the most commonly recommended asset mix based on these seven asset classes:
- U.S. stocks (large, medium, small)
- Non-U.S.stocks (developed and emerging markets)
- Resources (natural resources and commodities)
- Real Estate (REITs)
- U.S. Bonds (aggregate bonds and TIPS)
- Non-U.S. Bonds (international bonds)
- Cash (U.S. Cash)
Deciding to invest in multiple asset classes is what diversification is all about. Asset allocation is deciding how much to invest in each class.
As you can see from Israelsen's list, there are seven major asset categories and 12 sub-categories (hence, the "7Twelve" label).
I've been doing this with a balanced portfolio for much of my investing life. Only recently (leading up to retirement and then in retirement), I shifted to assets (and specific investments) that were more income-oriented, which effectively reduced the diversity of my portfolio.
Here's what my portfolio looked like at the end of 2021. As you can see, I was fairly diversified but conspicuously absent were precious metals, natural resources, commodities, and non-U.S. bonds. (I also had no investments in cryptocurrency.)
- U.S. large-cap value stocks (specifically, dividend-paying stocks)
- U.S. small-cap value stocks (small position)
- International large-cap value stocks (dividend payers)
- Alternatives (preferred stocks and REITs)
- Fixed income (blended bonds and TIPS)
My asset allocation at that time was roughly 40% stocks and alternatives and 60% bonds and cash. But since the start of 2022, I've adjusted my asset allocation and investments in anticipation of higher inflation and rising interest rates.
(A quick reminder: You shouldn't take anything I say here as financial advice. Everyone's situation, including time horizon and risk tolerance, is different, so please do your research and talk with your financial advisor if you have one or someone you trust before making any changes. If you already have a well-diversified portfolio that suits your risk tolerance, it may be best to stand pat or just tweak it.)
Ways to diversify
Certain investments hold up well and even outperform stocks during rising inflation.
This chart from Fidelity shows how various assets have performed since early 2021, when inflation began to heat up:
The best performer was commodities, followed by REITs, U.S. stocks, TIPs, and bonds. (Gold isn't shown on the chart, but it's up 7% over the last year.)
- Unexpected inflation is bad for nominal-return (i.e., non-inflation-adjusted) bonds.
- TIPS have provided the best hedge against inflation. The problem is low real (inflation-adjusted) interest rate returns. (Their current real yields are negative, at least out to 10 years as of April 11, 2022, and even out to 30 years, they are only about 0.25%).
- Cash has not been a reliable inflation hedge.
- Stock index funds "work" over a very long-term horizon, but they're a negative hedge in shorter time frames, tending to fall when inflation rises.
- Real estate has been a good hedge against inflation. (In particular, residential real estate values tended to rise with incomes.)
- Commodities are another traditional inflation hedge that negatively correlates to growth assets (equities) but are highly volatile.
In this summary statement, he emphasizes the value that a diversified portfolio containing these assets can provide:
The best hedge against inflation – admittedly imperfect – has been a diversified portfolio of real assets, including TIPS, real estate, commodities used sparingly, and specific equities selected for their ability to pass through cost increases to consumers. International equities and debt may also be a hedge against domestic inflation due to the currency effect.
Based on that statement, it would appear that the best (and perhaps easiest) way to navigate an uncertain environment over the long run is through diversification and rebalancing—something that many of you (or your adviser) may already be doing.
A combination of stocks, real estate, cash/bonds, commodities, and precious metals may do better through multiple types of economic environments better than a basic 60/40 stock and bond portfolio because each element of that more diversified portfolio benefits from either inflation, deflation, growth, or stagflation.
That brings us back to what has happened over the last twelve months: As shown in the Fidelity chart above, commodity prices have responded strongly to supply and demand shocks, reflecting the sharp price increases in almost all commodities since the supply chain problems since the easing of the pandemic. A broad-based basket of commodities is up more than 20%.
Real estate (REITs) is also up sharply as it has rebounded from its pandemic lows.
U.S. stocks haven't done as well as commodities and REITs and tend to keep up with inflation, but the markets are down this year mainly due to pending interest rate increases.
Bonds are also down for the same reason. TIPS have done a little better since inflation kicked into high gear last year.
I receive regular updates on Sound Mind Investing's model portfolios. They have shifted a little (by that, I mean positions of 5% to 10%) toward commodities, gold, real estate, TIPS, and other inflation hedges in their Fund Upgrading and Dynamic Asset Allocation strategies (requires subscription).
(They have also increased their cash holdings significantly, likely anticipating more bad market days to come.)
I wouldn't say I like making significant changes to my investing strategy (which I would describe as "strategic income with growth"), my portfolio's asset allocation, or specific investments. But because I believe we're in a time of significant change and extreme uncertainty, I think it would be unwise to assume that what's worked well in the past will continue to do so in the future.
I haven't made radical, wholesale changes (like selling everything and going to cash and/or gold). But as I have evaluated my portfolio, considering inflation and rising interest rates, I've reduced my allocation to stocks and some bonds and have taken positions in precious metals (gold), commodities, and TIPS. I've also beefed up my cash reserves (bucket) to avoid selling assets for income during a prolonged down-market.
Here is what my portfolio currently contains:
- U.S. Stocks (dividend-paying and low volatility, U.S. and international)
- Real Estate (REITs index tracking ETF) – small position
- Precious Metals (gold index-tracking ETF) – moderate position
- Commodities (index-tracking ETF) – small position
- U.S. Bonds (blended, corporate, treasuries, and TIPS, short and intermediate term)
- International Bonds (total bond index and foreign treasury bonds)
Traditional model portfolios for someone my age would be 40% to 80% invested in bonds. But, with yields so low (though rising) and bond prices falling, I've shifted some assets away from stocks and bonds to real estate, commodities, gold, and cash. (I already had a position in TIPS, real estate, and cash.)
That said, my largest investments are still stocks, bonds, and cash.
The allocations to REITs, gold, and commodities have actually made my portfolio a little riskier (as these tend to be volatile). However, it would still be classified as "moderately conservative" based on my large allocation to bonds and cash.
You may have noticed that I still don't have any investments in cryptocurrency. That said, some suggest that taking a small position in crypto (which is not denominated in U.S. dollars—"fiat currency") is a way to further diversify your portfolio. I don't take issue with what, but I am not ready to do so just yet.
No investment is entirely inflation-proof. Historically, these investments have done well against higher inflation, but they're not wholly immune to inflation or rising interest rates. At our current "inflection point," both exert different pressures on the economy and consumers.
Impacts on my withdrawal strategy
With lower long-term stock and bond return expectations (perhaps less than inflation for the next year or two), I am fairly certain both income and growth wil be less in the coming years.
But I don't forsee significant reductions in my income requirements, and that may necessiate changes to my withdrawal strategy.
I'm not changing my basic bucket strategy. But lower returns and some diversification away from mainly income-producing assets means I will have less income from dividends and interest. That could necessitate a shift toward a more flexible withdrawal strategy that relies on income and growth.
My goal remains to preserve assets by spending dividends and interest that have filled my "cash bucket," but with some coming from growth assets such as stocks, gold, commodities, or real estate.
If necessary, here's how it would work: I'll continue to allow all dividends and interest to go to my "cash bucket" and withdraw from that to fund expenses. As I deplete my cash bucket and it needs to be "topped off," I'll sell some of my most appreciated assets, perhaps once or twice a year. (Hopefully, I won't need to do so more often than that.)
I know this sounds a little like market timing in reverse. But it's not really because I'm selling when I need to refill my income bucket, not because of what's happening in the markets at any given time.
You may be wondering what I'd do if all assets are down (like they are now).
Using a buckets system means keeping less volatile assets like cash and bonds on hand for near-term living expenses (i.e., approx. three years). I'll hopefully avoid having to sell more volatile assets like stocks, real estate, commodities, and gold when they are down significantly. I'll draw from cash and bond funds instead.
But I also know there are no guarantees–they could ALL be down at once (including bonds). I'm assuming that some will be down much less than others. That's the beauty of diversification!
Not all gloom and doom
A friend of the blog recently commented that my last article seemed a little "gloomy."
I am usually a pretty optimistic and upbeat guy, and I have a lot of confidence in the resiliency of our free-market economy. As I wrote previously,
. . . there are reasons for optimism due to accelerating advances in digitizing assets, decentralization, biotech, clean energy, and other innovative future economic growth opportunities, some of which may be big "game-changers."
So, barring some catastrophic event (like a world war), I think inflation, interest rates, and the economy, in general, will stabilize in the years ahead—but it will take time.
Part of wise stewardship is endeavoring to understand the current realities, no matter how unpleasant they may be, and respond accordingly. That's why I wrote these two articles and am tweaking my investment strategy.
Is it possible that I would be better off just leaving things alone? Perhaps—too much tinkering can lead to bad outcomes. But each of us has to do what we think is best so long as it doesn't violate our conscience or any biblical principles.
Uncertainty abounds, but . . .
My base case in the previous article is that the Fed will tighten monetary policy until something gives. It might be a recession or a near-recession slowdown that stabilizes and then reduces inflation.
The Fed always hopes for a "soft landing," meaning they want to reduce marginal demand "just enough" to decelerate from current overheated levels but not cause an outright recession.
Will they succeed? It's certainly technically possible, but their historical record of achieving that is relatively poor. They typically tighten monetary policy until a recession forms.
We've been through recessions in the past and will go through them in the future. Recessions aren't always bad for stocks, but they can be. Gold and commodities tend to do better when stocks underperform.
Rising rates can create opportunities to improve yield after bond prices stabilize. So, it might make sense to shift some assets to fixed-income investments with the best rates for a given level of risk (which is usually determined by term and credit quality).
One this is sure: we can't know the future. We can, however, embrace the wisdom of the past in light of the teachings of scripture. The implication is that prudent and cautious action, combined with faith and hope, not fear or despair or unbelief, is the way forward:
Therefore, preparing your minds for action, and being sober-minded, set your hope fully on the grace that will be brought to you at the revelation of Jesus Christ (1 Pet. 1:13, ESV).