Inflation likelihood and inflation protection

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mikeguima
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Inflation likelihood and inflation protection

Post by mikeguima » Sun Sep 08, 2019 6:14 am

Hi everyone,

I recenlty read an article by Ray Dalio on his opinion on paradigm shifts (https://www.linkedin.com/pulse/paradigm ... ray-dalio/), where he argues central banks will likely have to monetize government deficits in order to pay for large incoming liabilities (debt, pension health care), which can be inflationary and lead to devaluations in some of the main currencies in the world. He then suggestes gold (and perhaps inflation linked securities?) would perform best in such an environment:

"So, the big question worth pondering at this time is which investments will perform well in a reflationary environment accompanied by large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. It is also a good time to ask what will be the next-best currency or storehold of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system."

The likelihood of this scenario unfolding is debatable, but it makes be wonder about inflation protection in broader terms. We've grown accostumed to an environment of low to no inflation, given multiple deflationary trends in place: excessive debt and related deleveraging, demographics, inherently deflationary technology progress, international trade, and probably a few more.

However, I can also picture a few trends /scenarios that would lead to inflation surprises:
1. Dalio's suggested monetization (demand side)´
2. Trade wars and reversal of international trade, which has benefited prices until now (supply side)
3. Oil shortages, given IEA's projections of currently low planned new oil supply to face forecasted demand (supply side)
4. Environmental regulation and carbon pricing driving prices up on carbon intensive industries, either by direct carbon pricing or forcing the adoption of pricier technologies (industries such as shipping, aviation, steel, cement and plastics come to mind as examples, with impacts on trade as well; supply side)

This is what I gathered in a quick brainstorming of mine, open to further ideas.

Taking this context, I would like to ask 1) what do you of the likelihood of scenarios like these unfolding and leading to inflation surprises in the future and 2) do you currently have/plan to have any deliberate inflation protection holdings in your portfolio and under what form?

Thank you.

P.S.: I'm Eurozone based and currently trying to decide whether I allocate some of my bond slice to EUR inflation linked securities, even though most inflation linked funds here include bonds with default risk (ex. Italian).
Last edited by mikeguima on Sun Sep 08, 2019 6:42 am, edited 1 time in total.

livesoft
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Re: Inflation likelihood and inflation protection

Post by livesoft » Sun Sep 08, 2019 6:34 am

I guess my response would be to try to make one's life less affected by inflation. That might mean reduce unnecessary expenses and learn to grow your own food. Also stay healthy enough to not need any drugs. Plus have a paid-for home that is low-maintenance and very energy efficient. Live in a place where you don't need to use a large vehicle very much, but can ride your bike to get around.
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vineviz
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Re: Inflation likelihood and inflation protection

Post by vineviz » Sun Sep 08, 2019 6:34 am

mikeguima wrote:
Sun Sep 08, 2019 6:14 am
Taking this context, I would like to ask 1) what do you of the likelihood of scenarios like these unfolding and leading to inflation surprises in the future and 2) do you currently have/plan to have any deliberate inflation protection holdings in your portfolio and under what form?
1) None of these scenarios are likely but "inflation surprises in the future" are virtually certain: the problem is accurately predicting the direction and magnitude of the surprises.

2) A globally diversified equity portfolio and a bond portfolio that includes TIPS are the easiest and cheapest protection you can buy against unexpectedly high inflation. A small allocation to commodity futures will possibly help if high inflation unexpectedly materializes and hurt if it doesn't. Pick your poison.

3) Stop paying attention to Ray Dalio.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

heyyou
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Re: Inflation likelihood and inflation protection

Post by heyyou » Sun Sep 08, 2019 2:07 pm

As mentioned, try to keep your necessary expenses low, expecting to adapt to whatever does occur.

Trying to hedge in advance, has risks. Often whatever was the perfect hedge for the most recent problem, doesn't work well for the next one, or the next one is just so delayed that the hedge becomes expensive to maintain for that long.

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FIREchief
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Re: Inflation likelihood and inflation protection

Post by FIREchief » Sun Sep 08, 2019 2:33 pm

My LMP is 100% individual TIPS. That's likely about as much protection as is possible for a US resident/investor.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

ivk5
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Re: Inflation likelihood and inflation protection

Post by ivk5 » Sun Sep 08, 2019 3:10 pm

mikeguima wrote:
Sun Sep 08, 2019 6:14 am
P.S.: I'm Eurozone based and currently trying to decide whether I allocate some of my bond slice to EUR inflation linked securities, even though most inflation linked funds here include bonds with default risk (ex. Italian).
Why not just build a Liability Matching Portfolio using EUR inflation-linked sovereign bonds from the highest credit quality countries (DE etc)?

You’ll get more precise control over duration and other characteristics than with a fund, and avoid unwarranted credit risk.

Stormbringer
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Re: Inflation likelihood and inflation protection

Post by Stormbringer » Sun Sep 08, 2019 3:51 pm

While I share the concern that governments may have no choice but to monetize the debt at some point, I have no idea how far in the future that may be, and it could be many decades from now. People have been freaking out over the national debt in the US for 30 years now. Japan's finances have been a disaster for decades. Yet, the governments of both countries are still able to issue massive amounts of new debt at historically low interest rates. Also, a global debt crisis might itself be extremely deflationary, so I don't know how much inflation we would actually get. And maybe some technological advancement comes along and we get a massive burst of economic growth that brings the debt back under control like what happened in the 1990's.

My gut tells me that we expect extremely low interest rates for a long, long, long time, and probably low inflation as well. Even so, having some inflation protection in the portfolio is probably wise.
"Compound interest is the most powerful force in the universe." - Albert Einstein

JBTX
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Re: Inflation likelihood and inflation protection

Post by JBTX » Sun Sep 08, 2019 3:57 pm

I read through the entire thing and he makes a lot of sense. I generally agree with his macro conclusions, growing public debt which will require monetization and growing unfunded liabilities that will have political blowback, which we are already seeing.

Of course the trick is in the timing. It could take many years or even decades to play out, or it could happen sooner than we like.

I'm probably going to consider increasing my portion of fixed income into inflation protected securities, which has fallen off over the last decade, and perhaps dabble a bit more into gold silver and commodities, all of which I fundamentally dislike as long term investments, although I could never put too much into those spaces.

Guys like Dahlio and to a lesser extent Grantham are great long term macro thinkers, but the ability to translate those visions into investment strategies for the masses is notoriously difficult.

KlangFool
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Re: Inflation likelihood and inflation protection

Post by KlangFool » Sun Sep 08, 2019 4:03 pm

Folks,

If you believe that we are heading towards a high inflation period, why are you pre-paying and/or paying off a 30 years sub-4% nominal fixed-interest rate mortgage? Please explain that to me?

I have many folks posting on how we are going to high inflation period and they are claiming that they are pre-paying and/or paying off their 30 years sub-4% nominal fixed interest rate mortgage on the same thread.

The short answer to the question is very simple. Keeping your 30 years sub-4% nominal fixed interest-rate mortgage as an inflation hedge. The bond and/or "negative bond" argument does not work in this context.

As for folks outside of the USA, my apology to you for not having this option in your locale.

KlangFool

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CoinCounter
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Re: Inflation likelihood and inflation protection

Post by CoinCounter » Sun Sep 08, 2019 4:06 pm

vineviz wrote:
Sun Sep 08, 2019 6:34 am

2) A globally diversified equity portfolio . . . .
This seems like the easiest answer. Aren't the international funds most people have in their portfolio baskets of assets priced in other currencies? It's that already a great deal of inflation protection for anyone with a significant international position? What am I missing?
I think what I am seeing here is the ol' behavioral finance trap of loss aversion. Namely, folks rate losses twice as bad as the corresponding gains. Get over it. Get over loss aversion. - livesoft

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willthrill81
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Re: Inflation likelihood and inflation protection

Post by willthrill81 » Sun Sep 08, 2019 4:10 pm

vineviz wrote:
Sun Sep 08, 2019 6:34 am
mikeguima wrote:
Sun Sep 08, 2019 6:14 am
Taking this context, I would like to ask 1) what do you of the likelihood of scenarios like these unfolding and leading to inflation surprises in the future and 2) do you currently have/plan to have any deliberate inflation protection holdings in your portfolio and under what form?
1) None of these scenarios are likely but "inflation surprises in the future" are virtually certain: the problem is accurately predicting the direction and magnitude of the surprises.

2) A globally diversified equity portfolio and a bond portfolio that includes TIPS are the easiest and cheapest protection you can buy against unexpectedly high inflation. A small allocation to commodity futures will possibly help if high inflation unexpectedly materializes and hurt if it doesn't. Pick your poison.

3) Stop paying attention to Ray Dalio.
:thumbsup
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JBTX
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Re: Inflation likelihood and inflation protection

Post by JBTX » Sun Sep 08, 2019 4:12 pm

Stormbringer wrote:
Sun Sep 08, 2019 3:51 pm
While I share the concern that governments may have no choice but to monetize the debt at some point, I have no idea how far in the future that may be, and it could be many decades from now. People have been freaking out over the national debt in the US for 30 years now. Japan's finances have been a disaster for decades. Yet, the governments of both countries are still able to issue massive amounts of new debt at historically low interest rates. Also, a global debt crisis might itself be extremely deflationary, so I don't know how much inflation we would actually get. And maybe some technological advancement comes along and we get a massive burst of economic growth that brings the debt back under control like what happened in the 1990's.

My gut tells me that we expect extremely low interest rates for a long, long, long time, and probably low inflation as well. Even so, having some inflation protection in the portfolio is probably wise.
My thoughts are very similar to yours. Translating these sort of long term macro trend analyses into investment strategies is notoriously difficult, and made more difficult when the trends become prolonged and compared to the "why not 100% stocks" crowd you come out looking like an idiot.

JBTX
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Re: Inflation likelihood and inflation protection

Post by JBTX » Sun Sep 08, 2019 4:14 pm

CoinCounter wrote:
Sun Sep 08, 2019 4:06 pm
vineviz wrote:
Sun Sep 08, 2019 6:34 am

2) A globally diversified equity portfolio . . . .
This seems like the easiest answer. Aren't the international funds most people have in their portfolio baskets of assets priced in other currencies? It's that already a great deal of inflation protection for anyone with a significant international position? What am I missing?
Because the trends he is referencing are largely global.

JBTX
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Re: Inflation likelihood and inflation protection

Post by JBTX » Sun Sep 08, 2019 4:17 pm

KlangFool wrote:
Sun Sep 08, 2019 4:03 pm
Folks,

If you believe that we are heading towards a high inflation period, why are you pre-paying and/or paying off a 30 years sub-4% nominal fixed-interest rate mortgage? Please explain that to me?

I have many folks posting on how we are going to high inflation period and they are claiming that they are pre-paying and/or paying off their 30 years sub-4% nominal fixed interest rate mortgage on the same thread.

The short answer to the question is very simple. Keeping your 30 years sub-4% nominal fixed interest-rate mortgage as an inflation hedge. The bond and/or "negative bond" argument does not work in this context.

As for folks outside of the USA, my apology to you for not having this option in your locale.

KlangFool
I largely agree. But I doubt the participants of this thread are among those pushing to aggressively pay off 2.5% mortgages because it makes you feel warm and fuzzy.

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Blueskies123
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Re: Inflation likelihood and inflation protection

Post by Blueskies123 » Sun Sep 08, 2019 4:24 pm

As others have said, TIPs are a way to help offset inflation although they are not perfect. I have half my bonds in TIPS so I have some protection for unexpected inflation. TIPs do not protect you against increasing real interest rates but at least they help a bit.
I also have a fair amount in international stocks. Some people have bought a small percent in gold.
Direct investment in real estate could also help but you have to know what you are doing.

KlangFool
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Re: Inflation likelihood and inflation protection

Post by KlangFool » Sun Sep 08, 2019 4:26 pm

JBTX wrote:
Sun Sep 08, 2019 4:17 pm
KlangFool wrote:
Sun Sep 08, 2019 4:03 pm
Folks,

If you believe that we are heading towards a high inflation period, why are you pre-paying and/or paying off a 30 years sub-4% nominal fixed-interest rate mortgage? Please explain that to me?

I have many folks posting on how we are going to high inflation period and they are claiming that they are pre-paying and/or paying off their 30 years sub-4% nominal fixed interest rate mortgage on the same thread.

The short answer to the question is very simple. Keeping your 30 years sub-4% nominal fixed interest-rate mortgage as an inflation hedge. The bond and/or "negative bond" argument does not work in this context.

As for folks outside of the USA, my apology to you for not having this option in your locale.

KlangFool
I largely agree. But I doubt the participants of this thread are among those pushing to aggressively pay off 2.5% mortgages because it makes you feel warm and fuzzy.
Yes, but I need to post this as a community service. Paying off a sub-4% mortgage may not give a person feel warm and fuzzy especially if the same person believes that we will have a very high inflation rate in the future. The person had just given up the best inflation hedge that he/she had.

KlangFool

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Phineas J. Whoopee
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Re: Inflation likelihood and inflation protection

Post by Phineas J. Whoopee » Sun Sep 08, 2019 5:54 pm

Blueskies123 wrote:
Sun Sep 08, 2019 4:24 pm
As others have said, TIPs are a way to help offset inflation although they are not perfect. I have half my bonds in TIPS so I have some protection for unexpected inflation. TIPs do not protect you against increasing real interest rates but at least they help a bit.
I also have a fair amount in international stocks. Some people have bought a small percent in gold.
Direct investment in real estate could also help but you have to know what you are doing.
Nor do any other marketable securities protect one against increasing real yields, at least not over the short term.

The upper-case S in TIPS stands for securities, so there's no need to construct a plural by making it lower case.

PJW

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FIREchief
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Re: Inflation likelihood and inflation protection

Post by FIREchief » Sun Sep 08, 2019 8:05 pm

Blueskies123 wrote:
Sun Sep 08, 2019 4:24 pm
TIPs do not protect you against increasing real interest rates but at least they help a bit.
I use a ten year ladder of individual TIPS. I would love it if real interest rates increased! :beer
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Inflation likelihood and inflation protection

Post by Angst » Mon Sep 09, 2019 11:48 am

KlangFool wrote:
Sun Sep 08, 2019 4:26 pm
Yes, but I need to post this as a community service. Paying off a sub-4% mortgage may not give a person feel warm and fuzzy especially if the same person believes that we will have a very high inflation rate in the future. The person had just given up the best inflation hedge that he/she had.

KlangFool
Not to dispute the above idea, but this does makes me wonder: As low as interest rates have been recently (internationally in particular), is there anything that precludes the existence of both falling rates and rising inflation? I suppose not. Although "inflation" certainly characterized the high rates environment of the 1970's, inflation is defined as an increase in prices (or drop in the value of money) and it's not necessarily tied to interest rates paid on bonds. Perhaps a low interest rates world does not preclude high inflation?

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Re: Inflation likelihood and inflation protection

Post by ivk5 » Mon Sep 09, 2019 12:30 pm

Angst wrote:
Mon Sep 09, 2019 11:48 am
KlangFool wrote:
Sun Sep 08, 2019 4:26 pm
Yes, but I need to post this as a community service. Paying off a sub-4% mortgage may not give a person feel warm and fuzzy especially if the same person believes that we will have a very high inflation rate in the future. The person had just given up the best inflation hedge that he/she had.

KlangFool
Not to dispute the above idea, but this does makes me wonder: As low as interest rates have been recently (internationally in particular), is there anything that precludes the existence of both falling rates and rising inflation? I suppose not. Although "inflation" certainly characterized the high rates environment of the 1970's, inflation is defined as an increase in prices (or drop in the value of money) and it's not necessarily tied to interest rates paid on bonds. Perhaps a low interest rates world does not preclude high inflation?
There is a strong presumption that the Fed will tighten monetary policy (raise the federal funds rate) to combat inflation well above target. That’s their core mission. So short term rates, at least, would definitely rise.

Of course there is also now an expectation that the Fed will act to maintain full employment; the two goals conflict under stagflation conditions, since monetary tightening tends to slow economic growth which tends to hurt employment. Monetary easing helps economic growth and employment but increases inflation risk. How the Fed would handle high inflation in a low/no- growth economy is not entirely predictable. There seems to be debate about how effective the Fed’s tools are for dealing with such a scenario, and also how likely it is to occur (which is a bit circular, since likelihood of stagflation may be impacted by economic actors’ perceptions of the Fed’s effectiveness).

The 70s were the early fiat currency days (gold standard abolished in 1971) and arguably not directly comparable to today.
Last edited by ivk5 on Mon Sep 09, 2019 12:36 pm, edited 2 times in total.

KlangFool
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Re: Inflation likelihood and inflation protection

Post by KlangFool » Mon Sep 09, 2019 12:34 pm

Angst wrote:
Mon Sep 09, 2019 11:48 am
KlangFool wrote:
Sun Sep 08, 2019 4:26 pm
Yes, but I need to post this as a community service. Paying off a sub-4% mortgage may not give a person feel warm and fuzzy especially if the same person believes that we will have a very high inflation rate in the future. The person had just given up the best inflation hedge that he/she had.

KlangFool
Not to dispute the above idea, but this does makes me wonder: As low as interest rates have been recently (internationally in particular), is there anything that precludes the existence of both falling rates and rising inflation? I suppose not. Although "inflation" certainly characterized the high rates environment of the 1970's, inflation is defined as an increase in prices (or drop in the value of money) and it's not necessarily tied to interest rates paid on bonds. Perhaps a low interest rates world does not preclude high inflation?
If the interest rate drop, you refinance your mortgage.

KlangFool

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Re: Inflation likelihood and inflation protection

Post by asif408 » Mon Sep 09, 2019 12:51 pm

vineviz wrote:
Sun Sep 08, 2019 6:34 am
1) None of these scenarios are likely but "inflation surprises in the future" are virtually certain: the problem is accurately predicting the direction and magnitude of the surprises.

2) A globally diversified equity portfolio and a bond portfolio that includes TIPS are the easiest and cheapest protection you can buy against unexpectedly high inflation. A small allocation to commodity futures will possibly help if high inflation unexpectedly materializes and hurt if it doesn't. Pick your poison.

3) Stop paying attention to Ray Dalio.
I largely agree with vineviz, with the exception of the commodity futures (I use commodity producer equities to avoid the issue of contango). I would also add a tilt toward value stocks worldwide could also be a potential inflation hedge. William Bernstein's Deep Risk book is probably the best I've read when considering inflationary/deflationary scenarios and how to protect against them.

The good news today is if you decide to tilt toward the inflation hedges on the equity side, international stocks (developed ex-US and emerging markets) are cheaper than domestic stocks, value stocks are cheaper than growth stocks worldwide (on a relative basis; value stocks are always cheaper on an absolute basis by definition), and commodity producers, with the exception of gold miners in the last year or so, have significantly underperformed a boring old Total US stock market index in the last decade. So you can get most of the inflation hedges on the equity side at a discount today, probably in part due to the fact that inflation in most of the world has been fairly benign in the last decade.

Whether or not that results in outperformance in the future is not something I cannot predict, but if inflation does pick up diversifying into these areas should benefit you. I think you'll have to research on your own and decide what the likelihood of inflation is. My personal opinion is that it is high for me, because I potentially have another 50-60 years to live. If you're much older you might not see another inflation bout in your lifetime.
Last edited by asif408 on Mon Sep 09, 2019 2:15 pm, edited 2 times in total.

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Re: Inflation likelihood and inflation protection

Post by greg24 » Mon Sep 09, 2019 1:02 pm

KlangFool wrote:
Sun Sep 08, 2019 4:03 pm
If you believe that we are heading towards a high inflation period, why are you pre-paying and/or paying off a 30 years sub-4% nominal fixed-interest rate mortgage? Please explain that to me?
You've created a strawman by combining two distinct groups on this board.

Some people on the forum like to get rid of their debt.

Some, like the poster of this thread, fear inflation and are wondering how to take steps to combat it.

Show me the poster who is arguing to both pay down their mortgage while also worried about inflation fears. I don't think they exist.

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Re: Inflation likelihood and inflation protection

Post by Artsdoctor » Mon Sep 09, 2019 1:14 pm

Angst wrote:
Mon Sep 09, 2019 11:48 am
KlangFool wrote:
Sun Sep 08, 2019 4:26 pm
Yes, but I need to post this as a community service. Paying off a sub-4% mortgage may not give a person feel warm and fuzzy especially if the same person believes that we will have a very high inflation rate in the future. The person had just given up the best inflation hedge that he/she had.

KlangFool
Not to dispute the above idea, but this does makes me wonder: As low as interest rates have been recently (internationally in particular), is there anything that precludes the existence of both falling rates and rising inflation? I suppose not. Although "inflation" certainly characterized the high rates environment of the 1970's, inflation is defined as an increase in prices (or drop in the value of money) and it's not necessarily tied to interest rates paid on bonds. Perhaps a low interest rates world does not preclude high inflation?
You can definitely have the Fed decreasing the Federal funds rate in the setting of inflation. We all have a certain presumption that the Fed is an independent entity but if you study the history of the Fed, you will find that this independence occurs variably in the past and depends on certain . . . relationships.

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Re: Inflation likelihood and inflation protection

Post by Angst » Mon Sep 09, 2019 1:31 pm

KlangFool wrote:
Mon Sep 09, 2019 12:34 pm
If the interest rate drop, you refinance your mortgage.

KlangFool
:sharebeer

KlangFool
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Re: Inflation likelihood and inflation protection

Post by KlangFool » Mon Sep 09, 2019 4:25 pm

greg24 wrote:
Mon Sep 09, 2019 1:02 pm
KlangFool wrote:
Sun Sep 08, 2019 4:03 pm
If you believe that we are heading towards a high inflation period, why are you pre-paying and/or paying off a 30 years sub-4% nominal fixed-interest rate mortgage? Please explain that to me?
You've created a strawman by combining two distinct groups on this board.

Some people on the forum like to get rid of their debt.

Some, like the poster of this thread, fear inflation and are wondering how to take steps to combat it.

Show me the poster who is arguing to both pay down their mortgage while also worried about inflation fears. I don't think they exist.
greg24,

They exist. It is the same group that worried about the government's debt and so on. Just wait a few days and some folks will post that.

KlangFool

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Re: Inflation likelihood and inflation protection

Post by abuss368 » Mon Sep 09, 2019 4:37 pm

No one knows what the future will hold for inflation. You can invest in inflation protected bonds if you feel you are at risk to unexpected inflation.

Tune out the noise.
John C. Bogle: "Simplicity is the master key to financial success."

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ray.james
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Re: Inflation likelihood and inflation protection

Post by ray.james » Mon Sep 09, 2019 4:51 pm

If near retirement - social security, TIPS, paid off home works well overall in most scenarios.
If accumulating - mortgage, diversified stocks, limiting consumption of wants.
When in doubt, http://www.bogleheads.org/forum/viewtopic.php?f=1&t=79939

GAAP
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Re: Inflation likelihood and inflation protection

Post by GAAP » Mon Sep 09, 2019 5:52 pm

mikeguima wrote:
Sun Sep 08, 2019 6:14 am
Taking this context, I would like to ask 1) what do you of the likelihood of scenarios like these unfolding and leading to inflation surprises in the future and 2) do you currently have/plan to have any deliberate inflation protection holdings in your portfolio and under what form?
1: If the scenarios were predictable (seemed likely), then why would they lead to surprise inflation? Certainly, they could lead to inflation in general, but surprise inflation means inflation that isn't priced into the market.

2: A small fixed income allocation for short-term TIPS (would change to something else if we moved to another country). For extended inflation, a small allocation to domestic REIT (not perfect, but partially effective). I couldn't stomach the costs of commodity-based protection, but would choose a broad-based commodity index tracking fund if I could.
“Adapt what is useful, reject what is useless, and add what is specifically your own.” ― Bruce Lee

feh
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Re: Inflation likelihood and inflation protection

Post by feh » Tue Sep 10, 2019 11:58 am

During accumulation: no TIPS.

During retirement: 20% of FI is TIPS.

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