In an investment landscape traditionally dominated by stocks and bonds, alternative investments have begun to stake their claim as valuable diversifiers, especially in scenarios where high inflation can negatively impact traditional asset returns. Among these alternatives, Merchant Cash Advances (MCAs), real estate, collectibles, hedge funds, private equity, and many more have attracted significant and growing interest from investors.
When building portfolios, it’s essential to incorporate inflation protection strategies, and doing so necessitates broad diversification across multiple asset classes and strategies. Protecting your portfolio against inflation is like setting up a shield against the erosion of your real returns. Having a sufficient representation of asset classes that can pace with or outpace inflation is the first layer of this shield.
While things like traditional savings accounts offer safety and liquidity, they are one of the worst places to keep your money, especially during inflationary periods. Data from the FDIC in 2023 showed that the national average interest rate for savings accounts was just 0.06%. This is massively below the current U.S. inflation rate and so doesn’t even bear considering as a strategy.
You Are a Portfolio Architect
That may be obvious enough, however, the work doesn’t stop there. Your portfolio needs to be flexible, capable of navigating the ever-changing economic landscapes. This includes not only transitioning between recessionary and non-inflationary growth phases but also gearing up to handle periods of inflation.
Here’s the tricky part: When inflation rises structurally, its connection with economic growth can loosen. Meaning, even with monetary policy tightening, equities, and bonds could falter simultaneously. As a result, diversifying your portfolio becomes a complex task, requiring more careful planning and strategic execution. Essentially, in such scenarios, your role is one of an architect, working to build robust downside protection into your portfolio.
We are here to help. This article will explore the importance of alternative investments for portfolio diversification, focusing particularly on techniques for high inflation scenarios. By drawing on historical data and real-life examples, we will provide you with a clear understanding of these often-overlooked investment vehicles and how they can fortify your portfolio against inflation’s erosive effects.
Inflation and Its Impact on Portfolio
When discussing investment portfolios, inflation plays a pivotal role that cannot be overstated. Very simply, inflation refers to the gradual increase in the price of goods and services in an economy over time. Understanding the impact of inflation on your investment portfolio is crucial for effective financial planning.
According to the Bureau of Labor Statistics, the average annual U.S. inflation rate from 1913 to 2021 was approximately 3.1%. Whilst this might seem like a small number, even at this rate, the purchasing power of $1 can be halved in roughly 23 years.
At the heart of inflation’s impact is the erosion of your purchasing power. To illustrate: if you stashed $10,000 under your mattress in 1990, it would have the equivalent purchasing power of around $5,200 today.
Effect on Fixed Income Investments
Fixed-income investments, such as bonds, are particularly vulnerable to inflation. Bonds typically pay a fixed interest rate (sometimes called a coupon) over a specified period. When inflation rises, the purchasing power of these fixed-interest payments falls, reducing the real returns for bondholders. Moreover, central banks often hike interest rates to curb inflation, which leads to a decline in existing bond prices.
For example, the 10-year Treasury yield in the U.S. was at 1.88% at the end of 2019, but it climbed to 3.6% as of June 2023 in response to inflationary pressures, causing bond prices to drop.
Impact on Equities
Inflation’s effect on equities, or stocks, is more complex. Companies can sometimes pass on increased costs to consumers, preserving their profitability in the face of inflation. But it’s not always feasible, and high inflation can squeeze profit margins, negatively impacting stock prices.
During the high inflation periods of the 1970s, the S&P 500 Index saw a real return (adjusted for inflation) of -1.36% annually. It’s rare that we see an overall net loss on the S&P 500, but the 1970s proved that it was possible and that it’s very bad news.
The Bottom Line: Inflation Impact Portfolio
Inflation, though seemingly a macroeconomic concern, has direct implications for individual investors. The erosion of purchasing power and the potential impacts on bonds and stocks mean that ignoring inflation when crafting an investment strategy could result in significantly lower-than-expected real returns. In turn, this could decimate retirement plans or future business ventures.
In essence, to safeguard your investment portfolio against inflation, diversification is key. We write about it pretty much constantly. And we are about to do it again.
Alternative Investments as a Diversification Strategy
While traditional investments like stocks and bonds have historically provided solid returns, they are not immune to economic forces such as inflation. Recently, the death of the 60/40 portfolio has been making headlines after a run of poor performance. This is where the value of alternative investments can come into play.
The Yale University Endowment, for instance, increased its allocation to alternative investments from 20% in 1990 to a whopping 60% in 2020. This has not only helped Yale to achieve a higher return but also to lower the overall portfolio risk thanks to the low correlation of alternative investments with traditional ones.
Yale reports that as they allocated more of the Endowment to the alternative asset classes, “risks plummeted for both spending volatility and purchasing power degradation”.
As Yale reports, one of the key factors in alternative assets’ ability to bring these huge benefits to a portfolio lies in their low correlation.
​​Understanding Low Correlation and its Role in Portfolio Diversification
Low correlation refers to a situation where different assets within a portfolio do not move in tandem. In other words, the price changes of these assets are not strongly linked. For example, if Asset A and Asset B have a low correlation, when Asset A’s price increases, Asset B’s price does not necessarily increase — it might stay the same or even decrease.
This characteristic of low correlation plays a crucial role in the realm of portfolio diversification, adding a protective layer to your investments. Here’s how:
Risk Mitigation: If one asset declines in value, another low-correlated asset might remain stable or even increase in value, potentially offsetting the loss. This helps reduce the portfolio’s overall risk.
Performance Smoothing: Having low-correlated assets can lead to smoother overall portfolio performance over time, as the different assets may perform well in different market conditions.
Potential for Higher Returns: Diversification across low-correlated assets opens up opportunities to benefit from varied market segments, potentially enhancing overall returns.
In essence, a low correlation between portfolio assets aids in spreading risk and enhancing potential returns, making it a foundational component of an effective diversification strategy.
MCAs as a Diversification Strategy
As you know, diversification is a key strategy for reducing risk and potentially enhancing returns over the long term. One increasingly popular asset class for diversification is Merchant Cash Advances (MCAs).
MCAs offer a unique investment avenue, different from traditional asset classes like stocks and bonds. In essence, an MCA is a financing option where a business receives a lump-sum cash advance from a lender, agreeing to repay the advance, plus a premium, from a portion of its future sales.
Additionally, because repayment is based on a percentage of daily sales, there’s an inherent buffer against credit risk during economic downturns. If a business’s sales slow down, so too does the repayment, which can lead to extended investment duration but maintains the security of the initial investment.
MCA: A Low Correlation Asset
MCAs provide a return that’s not directly correlated with broader market conditions, making them a compelling addition to a diversified portfolio. For instance, during the 2008 financial crisis, many traditional investments saw catastrophic declines, with millions in wealth wiped out almost overnight. However, many alternative investments, including MCAs, performed differently, providing some reassuring portfolio stability during an otherwise highly volatile time.
Data from Lehrner shows that a majority of the alternative asset classes that they studied outperformed most of the traditional assets like stocks and bonds throughout the 2007-2009 financial crisis.
At Supervest, we offer a short-term 12-month MCA note with a target return of 10%, a midterm 24-month note with a target return of 12%, and a fully self-directed investment platform where you have total control over the type, spread, and duration of your holdings.
Mixing and matching between these different durations, industries, and types of MCA can provide further layers of protection against market volatility and spread your overall portfolio risk.
MCAs present an interesting option for those looking to diversify their investment portfolio beyond traditional asset classes. They offer a potential hedge against market volatility and a chance for robust returns. However, as with all investment decisions, understanding the risk-reward dynamics is critical.
For those able to navigate these complexities, MCAs could serve as a powerful tool in a well-diversified investment portfolio. Investing with a company that has high levels of transparency, a strong track record, and rigorous due diligence processes is highly recommended.
Other Alternative Investments
Apart from MCAs, there are various other alternative investments like real estate, collectibles, private equity, hedge funds, and more that might be useful during high inflation scenarios like the one we are currently in.
For example, commodities like gold have traditionally been viewed as a safe haven during high inflation periods. Between 2000 and 2023, the price of gold increased from $279.11 per ounce to $1,962.04 per ounce. Real estate is another popular alternative asset class, though not a perfect one. Whilst real estate investors can benefit from some tax breaks and deductions which can offset income and profits, it is a relatively illiquid asset and can also depreciate due to economic downturns, location factors, and more.
Hedge funds are designed to make money whether markets are rising or falling, aiming to provide steady returns. Likewise, the flexibility of hedge funds allows them to make bold, concentrated bets, and use leverage, often aiming for high absolute returns. Despite this, hedge funds are renowned for charging high management fees and additional performance fees, which can seriously erode your returns. Further, hedge funds do not usually disclose their investment strategies, making it hard to understand the risks involved, and many funds have lock-up periods during which time you cannot withdraw your money.
Private equity, as an alternative asset, can also offer a low correlation to the traditional stock market. PE has the potential for good returns, as firms aim to improve the operations of the companies they invest in. On the other hand, investments in private equity are typically locked up for years, offering low liquidity. Private equity also often requires a high minimum investment, and they can be pretty complex instruments. The risk of company failure is real, meaning there’s potential for significant losses.
What you decide on will always come back to your own personal risk-reward appetite and the timeline that you are investing for. All investments can depreciate in value and you will always run the risk that you get back less than you put in, regardless of where you invest.
Now, let’s briefly explore some traditional investments like CDs, bonds, and annuities, often sought after for their perceived inflation protection.
CDs: A Viable Inflation Hedge?
Certificates of deposit (CDs) are fixed-term deposits held at a financial institution that offers a specific fixed interest rate. Unfortunately, typical CDs do not offer built-in inflation protection. If you’re considering CDs to hedge against inflation, you would have to find CDs which are offering a higher rate than the inflation rate, which isn’t easy to do.
Annuities: A Good Inflation Hedge?
Annuities do not tend to serve as effective inflation hedges. Most annuity payouts are exposed to inflation risk because they generally provide a fixed monthly income. For example, suppose your annuity gives you a fixed $3,000 per month. If inflation surges by 12%, your annuity’s buying power drops to $2,640 — not an ideal scenario. However, variable annuities that adjust with interest rates may provide a semblance of inflation protection, compared to their fixed counterparts.
Long-term Bonds: Interest Rates and Inflation Risks
Long-term bonds, while popular for their steady and predictable income, also struggle during high inflation periods. Here’s why: Bond prices are inversely related to interest rates. When central banks hike interest rates to curb inflation, bond prices decline. Moreover, the fixed income from bonds becomes less valuable as inflation increases. For instance, if you buy a 10-year bond with a 2% annual return and inflation rises to 3%, your real return becomes negative, -1%.
In the late 1970s and early 1980s, U.S. inflation peaked above 13%, causing long-term bond values to plummet. So, while bonds can provide stability in a portfolio, they’re not always an effective inflation hedge.
Investing for inflation protection isn’t about avoiding these asset classes altogether. Each investment has its role and can provide value in different economic conditions. The key is diversification—holding a mix of assets that can perform well across various scenarios, thereby reducing risk and potential losses during inflationary periods.
Ultimately, investing with ‘inflation protection’ in mind requires careful planning, broad diversification, and a comprehensive understanding of how different asset classes respond to inflation. Balancing these factors can help ensure your portfolio is well-equipped to weather periods of high inflation.
Conclusion
Investing in a high-inflation environment can be challenging, and conventional investment wisdom may not always yield the desired results. This is why alternative investments, like MCAs, play an essential role in portfolio diversification. They not only offer potentially high returns but can also provide a hedge against inflation.
However, like all investment decisions, investing in MCAs or other alternative investments should not be taken lightly. They come with their own set of risks and complexities. As such, it is advisable to seek professional advice before venturing into this space.
In a world where inflation can significantly erode the real value of your investments, thinking outside the traditional investment box maybe not just beneficial, but necessary. As always, the key to successful investing lies in diversification, understanding the risks, and choosing the investments that best fit your unique financial goals and risk tolerance.
You can get started with MCAs here.
