Is Your 401k Prepared For Inflation?

Why, in a weak world economy with little inflation, is gold hitting new highs? Some investors, maybe even many investors, are concerned about the potential inflation that could come from the enormous expansion of the developed world's money supply, and erode the value of paper money. If inflation does explode, what will happen in the financial markets, and in particular in your 401k account?

Rob Arnott, a veteran successful money manager, published an essay today on how the typical little guy is poorly equipped for a regime, as the investment people like to say, of inflation. Investment choices in 401ks are based on the success of the 80s, 90s, and 00s, when pretty much everything did well.

Even after the "Lost Decade" [of 2000 through 2010], the 30-plus year period from 1980 through June 2010 witnessed U.S. stocks and bonds returning 10.8% and 8.8% respectively, delivering a 10.3% annualized return for the prototypical 60/40 investor. While this return was achieved by a scant few, [it] was an environment in which even bad decisions could lead to reasonably good outcomes.

Arnott posits that a long wave of inflation may be coming, and tells us what to do about it. (OK, he is somewhat biased on this point, because his firm, Research Affiliates, subadvises the PIMCO All-Asset Fund, which invests in just these sorts of inflation opportunities.) A while back I wrote several posts that reviewed the inflation of the 1970s and 1980s, and the lessons learned: First Second Third
To complement the traditional investments in stocks and bonds, Arnott says,

We need a third pillar that can help us during inflationary shocks and can afford us an opportunity to diversify away from stocks and bonds...

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In a high inflation environment, stocks and bonds will likely underperform other asset classes such as TIPS, commodities, and non-dollar assets [such as emerging market equities and bonds].

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So which asset classes perform best in high inflationary periods? Commodities when the economy is growing and TIPS when the economy is faltering. Commodity prices are pushed up by strong global demand; continued growth in emerging markets will likely fuel shortages of commodities. Like nominal bonds, TIPS prefer slower economic environments because they benefit from falling interest rates and lose value when rates increase.

And he includes this handy chart showing what works when:

And you don't have to go overboard and buy a lot of gold -- he is just suggesting that you lay in some protective assets before the inflation hits, and they become very expensive:

For investors who are confident that inflation will not be a serious issue in the coming 20 or 30 years, this can be a small pillar serving as an insurance policy in case they're wrong. For investors who fear that our soaring debts will trigger inflationary shocks in the years ahead, this can be a large pillar serving to protect their purchasing power as inflation crushes the purchasing power of their mainstream holdings.