The best asset allocation in a high inflation environment
The best asset allocation in a high inflation environment
I would like to have a bit better understanding of asset performance during high-inflation cycles and investment strategies to maximize real returns.
What assets perform better in a high-inflation (4%-8%) environment?
Here is my starting list:
Good
- low-interest fixed-rate mortgages (any other options?)
- real estate (we saw a big jump this year, what is really priced into this?)
- commodities (ETFs?)
Bad
- long-term bonds
- cash
How do stocks tend to perform in this type of environment? REITs? How alternative asset types would perform?
What assets perform better in a high-inflation (4%-8%) environment?
Here is my starting list:
Good
- low-interest fixed-rate mortgages (any other options?)
- real estate (we saw a big jump this year, what is really priced into this?)
- commodities (ETFs?)
Bad
- long-term bonds
- cash
How do stocks tend to perform in this type of environment? REITs? How alternative asset types would perform?
Re: The best asset allocation in a high inflation environment
Here's a paper discussing your question: https://www.gmo.com/americas/research-l ... inflation/creator wrote: ↑Thu Oct 21, 2021 1:42 pm I would like to have a bit better understanding of asset performance during high-inflation cycles and investment strategies to maximize real returns.
What assets perform better in a high-inflation (4%-8%) environment?
Here is my starting list:
Good
- low-interest fixed-rate mortgages (any other options?)
- real estate (we saw a big jump this year, what is really priced into this?)
- commodities (ETFs?)
Bad
- long-term bonds
- cash
How do stocks tend to perform in this type of environment? REITs? How alternative asset types would perform?
Re: The best asset allocation in a high inflation environment
It was a great read! Thanks for the link.
I wish the paper would cover S&P 500, REIT, and tech stock performance during times like this.
I wish the paper would cover S&P 500, REIT, and tech stock performance during times like this.
Re: The best asset allocation in a high inflation environment
Re-read the bit about cheap real assets as a long term store of value.
"The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next." ~Ursula LeGuin
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Re: The best asset allocation in a high inflation environment
Investopedia actually lists the S&P 500 as one option against inflation. Some REITS might do well but not mortgage REITS because of higher interest rates. Value stocks or funds seem to be recommended. Tech funds like VGT is considered a growth fund but it seems to have held its own in 2021.
Re: The best asset allocation in a high inflation environment
Sure, no problem. You can see from Exhibit 10 that the S&P would likely do ok overall during a high inflation environment (it kept up with CPI), but could lag for some time initially. And I think you could extrapolate that growth stocks like tech would not keep up with inflation, considering how well value stocks did in the last high inflation environment. REITs, who knows, if you consider REITs a cheap real asset currently then yes, if not then no.
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Re: The best asset allocation in a high inflation environment
This may sound a little tangential but in current tax law not all the taxes are inflation adjusted. For example the NIIT tax. Some tax credit phaseouts (which are an implicit tax) such as the child tax credit phasing out at $400K. Probably there are certain state taxes like this too.
So, for folks who expect inflation to bump them into these zones during retirement, then "investing" money from taxable accounts into paying the tax for Roth conversions may have a surprisingly high return even if your tax rate is expected to be slightly lower in retirement.
For example, if you're in the 24% bracket today, expect to be in the 22% bracket in retirement and expect inflation to cause the NIIT tax to hit most of your cap gains, and you have $ in taxable, then it may still make sense to do enough Roth conversions now to get you to a point that you'll only be in the 12% bracket when RMDs hit.
This is incredibly situation specific, and a high uncertainty play given that future tax law changes are unknowable yet inevitable.
But wanted to throw it out as an option that you may not have even considered.
So, for folks who expect inflation to bump them into these zones during retirement, then "investing" money from taxable accounts into paying the tax for Roth conversions may have a surprisingly high return even if your tax rate is expected to be slightly lower in retirement.
For example, if you're in the 24% bracket today, expect to be in the 22% bracket in retirement and expect inflation to cause the NIIT tax to hit most of your cap gains, and you have $ in taxable, then it may still make sense to do enough Roth conversions now to get you to a point that you'll only be in the 12% bracket when RMDs hit.
This is incredibly situation specific, and a high uncertainty play given that future tax law changes are unknowable yet inevitable.
But wanted to throw it out as an option that you may not have even considered.
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Re: The best asset allocation in a high inflation environment
The first thing you need to do is distinguish between expected and unexpected high inflation. The second thing you need to do is also specify what is going on with the macroeconomy in general.
Nominal bonds, for example, are typically fine when inflation is high but that was expected, because they would be priced (lower) to cover such inflation. The scenario they typically do poorly with is when inflation is unexpectedly high, because then prices have to drop to cover that unexpectedly high inflation. Conversely, they can do great when inflation is high by historic terms, but still lower than expected, because then prices will rise.
I note fixed-rate mortgages have the opposite relationships for obvious reasons. If you fix your mortgage and then inflation is unexpectedly high, you benefit because inflation will reduce the real value of your mortgage payments more than expected. But if that high inflation was expected, presumably you wouldn't be able to get such a low rate mortgage to begin with. Conversely, if inflation is unexpectedly low, your mortgage rate will likely be punitively high--which is not a problem if you can refinance. But if, say, you have lost your job or something like that, refinancing may not be so easy. So with personal debt (also low quality bonds, in fact), you need to be careful about the macroeconomic environment and how it might also be affecting your finances.
Stocks similarly tend to do fine in an expectedly high inflation scenario, IF that is not also a period of disappointing macroeconomic performance (aka stagflation). Unexpectedly high inflation is more complex, and it really depends on the individual company. As a rough rule of thumb, "value" stocks tend to do better with unexpectedly high inflation--unless there is a general macroeconomic crisis or malaise.
Unexpected stagflation, combining unexpectedly high inflation and also disappointing macroeconomic performance, can be a real nightmare scenario for stocks + nominal bonds portfolios. Real prices on both can drop, real income on both can be disappointing, and overall real returns can be disappointing over a pretty long period.
If unexpectedly high inflation is caused by devaluation of your home currency relative to other currencies, then obviously investments in stocks and bonds and such denominated in those other currencies can help. Similarly if there is a macroeconomic crisis or malaise more specific to your home country.
Diversified commodities can help if unexpectedly high inflation is caused by currency devaluation or some sort of supply shock.
Real estate is complex because it depends how you invest in it, the debt situation, where you are invested, the type of property and leases involved, and so on. But, basically, if you are talking about an investment in income-producing properties where the income can rise, at least in part, with inflation, and the debt is fixed, it should at least go up somewhat with unexpectedly high inflation--IF there is not some general macroeconomic crisis causing lots of defaults and vacancies and such. Again, if currency devaluation or a localized macroeconomic problem is an issue, real estate in other currency zones might help.
Finally, inflation-indexed bonds obviously tend to track unexpectedly high inflation quite well. Problem is these days they have really low expected rates of return, and also only really protect themselves from inflation. So, unless you are fine with low expected rates of return on your entire portfolio, considering these other investments might be necessary.
Nominal bonds, for example, are typically fine when inflation is high but that was expected, because they would be priced (lower) to cover such inflation. The scenario they typically do poorly with is when inflation is unexpectedly high, because then prices have to drop to cover that unexpectedly high inflation. Conversely, they can do great when inflation is high by historic terms, but still lower than expected, because then prices will rise.
I note fixed-rate mortgages have the opposite relationships for obvious reasons. If you fix your mortgage and then inflation is unexpectedly high, you benefit because inflation will reduce the real value of your mortgage payments more than expected. But if that high inflation was expected, presumably you wouldn't be able to get such a low rate mortgage to begin with. Conversely, if inflation is unexpectedly low, your mortgage rate will likely be punitively high--which is not a problem if you can refinance. But if, say, you have lost your job or something like that, refinancing may not be so easy. So with personal debt (also low quality bonds, in fact), you need to be careful about the macroeconomic environment and how it might also be affecting your finances.
Stocks similarly tend to do fine in an expectedly high inflation scenario, IF that is not also a period of disappointing macroeconomic performance (aka stagflation). Unexpectedly high inflation is more complex, and it really depends on the individual company. As a rough rule of thumb, "value" stocks tend to do better with unexpectedly high inflation--unless there is a general macroeconomic crisis or malaise.
Unexpected stagflation, combining unexpectedly high inflation and also disappointing macroeconomic performance, can be a real nightmare scenario for stocks + nominal bonds portfolios. Real prices on both can drop, real income on both can be disappointing, and overall real returns can be disappointing over a pretty long period.
If unexpectedly high inflation is caused by devaluation of your home currency relative to other currencies, then obviously investments in stocks and bonds and such denominated in those other currencies can help. Similarly if there is a macroeconomic crisis or malaise more specific to your home country.
Diversified commodities can help if unexpectedly high inflation is caused by currency devaluation or some sort of supply shock.
Real estate is complex because it depends how you invest in it, the debt situation, where you are invested, the type of property and leases involved, and so on. But, basically, if you are talking about an investment in income-producing properties where the income can rise, at least in part, with inflation, and the debt is fixed, it should at least go up somewhat with unexpectedly high inflation--IF there is not some general macroeconomic crisis causing lots of defaults and vacancies and such. Again, if currency devaluation or a localized macroeconomic problem is an issue, real estate in other currency zones might help.
Finally, inflation-indexed bonds obviously tend to track unexpectedly high inflation quite well. Problem is these days they have really low expected rates of return, and also only really protect themselves from inflation. So, unless you are fine with low expected rates of return on your entire portfolio, considering these other investments might be necessary.
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Re: The best asset allocation in a high inflation environment
How long will the 'high inflation environment' last? That's an extremely important consideration.
The Sensible Steward
Re: The best asset allocation in a high inflation environment
Some things you can do but obviously no guarantees.
First, is buy some cheaper stocks. Look at the Value indexes here in the United States and International Indexes abroad. Emerging Markets are cheaper than Developed Markets but keep in mind that EM is about 40% China. I still invest in EM but I have less enthusiasm than before.
Second, buy some TIPS. They have negative real yields after inflation but so do nominal bonds. TIPS protect you against unexpected inflation.
Third, you could buy a Natural Resources Sector Fund or ETF. Alternatively you could buy a Commodities index. I would expect positive returns from Natural Resources Stocks over longer periods of time and about zero performance from Commodities. I would consider Commodities to be analogous to paying premiums on an insurance policy, hopefully commodities would go up when you most need them to.
Fourth, you could buy Gold, the key is to maintain it as a fixed portion of your portfolio so you need to rebalance. I have no idea why this seems to work, as in the Harry Browne Permanent Portfolio, but it seems to. Rebalancing is the key. You could also buy Precious Metals Mining Stocks in a mutual fund or ETF, but I regard Gold and Precious Metals Stocks as Portfolio Insurance and not as an investment. Gold doesn't necessarily hedge inflation, it is more of a currency hedge.
Fifth, you could consider unhedged International Bonds to hedge the U.S. Dollar. This will work if the U.S. Dollar weakens relative to other currencies.
Sixth, you could reach for yield a bit with your bonds. Perhaps put a dash of such things as Emerging Market Bonds and High Yield Bonds in your fixed income portfolio. Perhaps Hybrid bonds like Convertibles and Preferreds. Stretch a bit but not by too much.
Seventh, REITs are often discussed as an inflation hedge. REITs have a reputation for fighting inflation, the academics say that the effect isn't as much as people perceive.
These are not recommendations, do your own research. Personally, I am doing all but number four. I have two Natural Resource stocks but no commodities. I also have done these things in smaller amounts, not a believer in extreme tilts. I am keeping my portfolio a bit stock heavy for someone my age as stocks will most likely handle inflation better than bonds, I am at 64% stocks compared to the 58% that Vanguard recommends for the 2025 retirement portfolio.
First, is buy some cheaper stocks. Look at the Value indexes here in the United States and International Indexes abroad. Emerging Markets are cheaper than Developed Markets but keep in mind that EM is about 40% China. I still invest in EM but I have less enthusiasm than before.
Second, buy some TIPS. They have negative real yields after inflation but so do nominal bonds. TIPS protect you against unexpected inflation.
Third, you could buy a Natural Resources Sector Fund or ETF. Alternatively you could buy a Commodities index. I would expect positive returns from Natural Resources Stocks over longer periods of time and about zero performance from Commodities. I would consider Commodities to be analogous to paying premiums on an insurance policy, hopefully commodities would go up when you most need them to.
Fourth, you could buy Gold, the key is to maintain it as a fixed portion of your portfolio so you need to rebalance. I have no idea why this seems to work, as in the Harry Browne Permanent Portfolio, but it seems to. Rebalancing is the key. You could also buy Precious Metals Mining Stocks in a mutual fund or ETF, but I regard Gold and Precious Metals Stocks as Portfolio Insurance and not as an investment. Gold doesn't necessarily hedge inflation, it is more of a currency hedge.
Fifth, you could consider unhedged International Bonds to hedge the U.S. Dollar. This will work if the U.S. Dollar weakens relative to other currencies.
Sixth, you could reach for yield a bit with your bonds. Perhaps put a dash of such things as Emerging Market Bonds and High Yield Bonds in your fixed income portfolio. Perhaps Hybrid bonds like Convertibles and Preferreds. Stretch a bit but not by too much.
Seventh, REITs are often discussed as an inflation hedge. REITs have a reputation for fighting inflation, the academics say that the effect isn't as much as people perceive.
These are not recommendations, do your own research. Personally, I am doing all but number four. I have two Natural Resource stocks but no commodities. I also have done these things in smaller amounts, not a believer in extreme tilts. I am keeping my portfolio a bit stock heavy for someone my age as stocks will most likely handle inflation better than bonds, I am at 64% stocks compared to the 58% that Vanguard recommends for the 2025 retirement portfolio.
A fool and his money are good for business.
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Re: The best asset allocation in a high inflation environment
Without a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
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Re: The best asset allocation in a high inflation environment
In order to have an investment that performs well in inflation you’d want an asset that has a positive expected return and one that correlates well with inflation. Good luck finding that
https://rationalreminder.ca/podcast/150
https://rationalreminder.ca/podcast/150
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Re: The best asset allocation in a high inflation environment
Without a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 amWithout a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
Re: The best asset allocation in a high inflation environment
That's how the 70s started, correct? Oil shocks driving up inflation at the beginning of the decade? That took ten years to finally resolve.phantom0308 wrote: ↑Mon Oct 25, 2021 4:57 amWithout a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 amWithout a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
I don't think prices at the grocery store are rising because of excess savings and supply problems at the ports.
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Re: The best asset allocation in a high inflation environment
The big difference between then and now is that the U.S. is now a net energy exporter.Whakamole wrote: ↑Mon Oct 25, 2021 8:31 amThat's how the 70s started, correct? Oil shocks driving up inflation at the beginning of the decade? That took ten years to finally resolve.phantom0308 wrote: ↑Mon Oct 25, 2021 4:57 amWithout a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 amWithout a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
The Sensible Steward
Re: The best asset allocation in a high inflation environment
Also, I remember learning there were multiple causes for the 1960's & 1970's inflation problems. The 1973 oil crisis was certainly one but also spending on the Vietnam War, and price/wage controls, and eventually people's expectations played a part as well.willthrill81 wrote: ↑Mon Oct 25, 2021 10:14 amThe big difference between then and now is that the U.S. is now a net energy exporter.Whakamole wrote: ↑Mon Oct 25, 2021 8:31 amThat's how the 70s started, correct? Oil shocks driving up inflation at the beginning of the decade? That took ten years to finally resolve.phantom0308 wrote: ↑Mon Oct 25, 2021 4:57 amWithout a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 amWithout a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
Re: The best asset allocation in a high inflation environment
My point was not that an energy crisis will happen again. It's that an inflation spiral, even one that appears temporary (as the oil shocks were at the time), can cause spiraling inflation that is difficult to get under control.sycamore wrote: ↑Mon Oct 25, 2021 11:23 amAlso, I remember learning there were multiple causes for the 1960's & 1970's inflation problems. The 1973 oil crisis was certainly one but also spending on the Vietnam War, and price/wage controls, and eventually people's expectations played a part as well.willthrill81 wrote: ↑Mon Oct 25, 2021 10:14 amThe big difference between then and now is that the U.S. is now a net energy exporter.Whakamole wrote: ↑Mon Oct 25, 2021 8:31 amThat's how the 70s started, correct? Oil shocks driving up inflation at the beginning of the decade? That took ten years to finally resolve.phantom0308 wrote: ↑Mon Oct 25, 2021 4:57 amWithout a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 am
Without a doubt for the foreseeable future as far as I can tell.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
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Re: The best asset allocation in a high inflation environment
I think many people conflate the 70s and 80s recessions with inflation. IMO, it was the recessions and bungled countercyclical and monetary policy that caused stagflation (as opposed to expansionary inflation).
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Re: The best asset allocation in a high inflation environment
The report refers to 2019-2020 which absolutely makes sense.willthrill81 wrote: ↑Mon Oct 25, 2021 10:14 amThe big difference between then and now is that the U.S. is now a net energy exporter.Whakamole wrote: ↑Mon Oct 25, 2021 8:31 amThat's how the 70s started, correct? Oil shocks driving up inflation at the beginning of the decade? That took ten years to finally resolve.phantom0308 wrote: ↑Mon Oct 25, 2021 4:57 amWithout a doubt as far as I can tell… unsure if extremely confident or extremely humble. If it were really without a doubt you should be putting all of your money into shorting bonds, right? It seems like if there’s as much debate as there is about the persistence of inflation by Wall Street, academics, Washington, Europe, etc then maybe there is some room for doubt.rossington wrote: ↑Mon Oct 25, 2021 4:26 amWithout a doubt for the foreseeable future as far as I can tell.willthrill81 wrote: ↑Sun Oct 24, 2021 10:09 am How long will the 'high inflation environment' last? That's an extremely important consideration.
My personal view is that a large part is transitory increase in demand b/c of stimulus that will run out as excess savings are spent and a large part is transitory supply b/c of pandemic that’ll resolve. I’m not willing to say I’m definitely right though. Inflation fears could make it more persistent I guess and it seems to be the only piece of economic news being discussed.
The next report will more than likely show those numbers have done a 180.
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
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Re: The best asset allocation in a high inflation environment
Usually, it is expansionary inflation. In this case, bonds dip a little as stocks rise (as spending occurs). During the recession, the inflation drops (good for bonds, bad of stocks since spending is limited). Under normal circumstances, the cycle keeps both in tandem.prioritarian wrote: ↑Mon Oct 25, 2021 2:05 pmI think many people conflate the 70s and 80s recessions with inflation. IMO, it was the recessions and bungled countercyclical and monetary policy that caused stagflation (as opposed to expansionary inflation).
Cost-push inflation, however, is the supply shock that people are worried about. That does not help most companies out to have that happen (since the consumer spending drops to pay for the elevated goods at the time of the shock). The companies can adjust for it, but that does not help them to really fix the problem in real dollars. Hence, you get stagflation if it is major enough. Monetary policy can worsen it, but stagflation can happen by itself.
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Re: The best asset allocation in a high inflation environment
Why are we proposing changing our asset allocations because inflation is high at the moment?
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Re: The best asset allocation in a high inflation environment
I bought two houses earlier this year for $630K each, they now have Zestimates for $807K and $803K respectively. We AirBnB's them and gross $5-9K a month on each one. Doesn't get much better than that...though I did buy Bitcoin at $8K pre-pandemic and it's nuts too.
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Re: The best asset allocation in a high inflation environment
Because either they are misunderstanding how all assets behave with inflation, or the major bond holders are getting bit by all the inflation risk that they carry.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.