The past two years have been volatile to say the least. The onset of the pandemic brought about short-term (lockdowns) and longer-term (supply chain issues) challenges for individuals, families, and businesses. This has led to an increase in the number of projections and prognostications from media and industry commentators that would make anyone feel like the sky was falling.
In particular, the two issues that are foremost on most investors' minds right now are the record level of stock prices and the rapid increase in inflation. To help investors put these issues in perspective and focus on growing their wealth, we would like to offer the following thoughts:
Record Stock Prices: It is common to hear that stocks hitting record prices is a signal that a decrease is imminent. However, we encourage you to remember that stock prices do not follow the laws of gravity. In fact, stocks are priced to deliver positive expected returns, which means that we should expect stocks to increase over time and by increasing, reach new highs. Recent research by Dimensional Fund Advisors (DFA) shows that there is little difference in subsequent returns between months when the market finished at record highs and months when the market finished at any level. For example, the subsequent 5 annualized compound return for months when markets ended at record highs is 9.90%, while the subsequent annualized return for months when markets ended at any level is 10.20%.
Inflation: It can be alarming when prices for everyday goods such as gas suddenly increase. It is likely more alarming because inflation has been historically low over the past two decades, and therefore expectations for inflation have decreased. However, additional research by DFA shows that between 1927 and 2020, the average above median inflation rate was 5.50% and during these higher inflation years, the only asset with a negative real return (asset return minus inflation) was short-term Treasury Bills. While this is reassuring, it is still the case that real asset returns were mostly lower in years with higher inflation versus years with lower inflation, so it is important for an investor to consider factors such as time horizon and risk tolerance because it may be that adding inflation protected assets such as Treasury Inflation Protected Securities (TIPS) to your portfolio is a prudent strategy.
At Stratus, we believe that wealth creation is like losing weight: focusing on the basics like a healthy diet and consistent exercise may not be sexy, but they work. Similarly, the best way to increase your wealth is to have a goals-based strategy that focuses on your risk tolerance, and then adjust that strategy based on changes to your goals and risk tolerance, and not on the ongoing concerns of third parties with no knowledge of your unique situation.