Inflation is like beauty. Despite thinking, or being deceived into thinking, that a universal measurement is possible, what I see is different from what you see.
Last year I wrote a couple of posts on the effects of the recent inflation surge on me and my family. Other than highlighting my bad call on transitory inflation, my goal was to describe how headline inflation, the CPI figure of the country where you live, do not portray what you and I actually experience. The CPI is an index of goods and services that is supposed to represent the consumption of the average citizen of that country: a person that does not exist. Not the “inflation truther” type of argument, as if the CPI is kept artificially low, but the fact that we all spend money in different ways.
I was really curious when I saw a Vanguard paper on “Personalized Inflation Hedging” on Bankeronwheels’ weekly reading list.
The paper starts from the same premise as my posts (confirmation bias /on):
The CPI is used as a general benchmark for inflation and it is based on a basket-weighted approach. However, the headline CPI number might not reflect the sensitivity to inflation of a given individual, thereby making the case of personalisation. “personalized inflation” is an individual custom-weighted basket of the CPI components.
But it ends as…a great marketing bait (confirmation bias /off)?
The Data
The paper provides interesting insights on Personalized Inflation Beta: starting from US data (labour statistics and consumer surveys), researchers built estimated spending budgets for different cohorts (grouped by age, location and income level) and compared them with the benchmark CPI, the index that is published on a monthly basis.
Based on this analysis, the paper shows how inflation beta decreases as age increases:
This does not mean that older folks spend less (which seems to be true but it is not what is investigated here) but that as we grow, we tend to spend on items that are less volatile than what’s in the benchmark CPI.
The beta by location is as well an eye-opener. The main reason why people move outside a city is that is less expensive. The index for shelter, the service that a housing unit provides its occupants, is one of the largest parts of the CPI and, basically, assumes everyone is renting. Interest costs (such as mortgage interest), property taxes, real estate fees, most maintenance, and all improvement costs are part of the cost of the capital good and are also not treated as consumption items: they are not part of the CPI. In short, if you own your place in the city, you are way more hedged (assuming a fixed mortgage) against movements in the CPI than if you own outside the city.
Living in a rural area might feel less expensive today, but it exposes that person to higher cost shocks in the future, especially if in both scenarios they owned their place.
The analysis by income level is where things get ‘trickier’ and less informative, at least for me. Inflation by definition can only impact expenditures; as income grows, more and more expenditures become discretionary. I’m watching Fleishman Is in Trouble so I might be overly biased here (the idea of my daughter going to school in Zurich starts to terrify me) but I assume a lot of Vanguard’s data is influenced by guys trying to keep up with the Joneses. Private schools or Disneyland VIP tickets are not mandatory expenses but I bet there is a lot of them in the above data.
The best hedge against inflation
Talking about tv, if you are looking for a way to protect yourself from inflation, episode 3 of The Last of Us is the best possible manual available. Or almost any season of The Walking Dead. Ok, maybe do not follow the shows’ characters when they steal stuff. But if you own your shelter, grow your own food, use only discarded clothes, walk around and in your free time kill zombies enjoy your surroundings, you have no inflation problem. Maybe befriend a doctor, just in case.
Would you say mine is an over-complicated solution? Yes, I agree. But at least I have a point, whereas I do not think Vanguard does (other than, as I said, marketing).
The best way to hedge yourself against inflation is to grow your income (way) above your fixed costs. That’s it, give yourself plenty of flexibility. With the notion that you have some decision power over your fixed costs (not the survival part but what you might consider as non-negotiable, the difference between having money to buy food and deciding to go to the restaurant three times per week). You do not need a fancy financial modelling tool for this.
The Myth of the Perfect Hedge
I guess 2022 did not teach you anything, uh? 😉 Unfortunately, there is no asset that mimics inflation rates, i.e. goes up (and down) by the same amount as inflation. Not gold, not inflation-linked bonds, not oil…and not Bitcoin. That’s on a year-to-year basis. [you might find, as I did, some Absolute Return funds that benchmark themselves as CPI + spread: that’s bait, do not fall for it]
If you want an asset that BEATS inflation, but over the long run, you have plenty:
Stocks, sometimes bonds and even cash (Bills), did it!
The above considerations are valid at portfolio level as well. Unless you run a tactical portfolio that goes on/off its components…at that point, congrats to you, open a hedge fund, buy a sports franchise and enjoy life.
Who wants to hedge against inflation?
I think this is the better question. Let’s start from the two examples used by Vanguard:
Maria represents the “young adult” category, the one that is overly exposed to inflation shocks due to its high beta. The Vanguard model suggests a portfolio that is higher risk but…higher Sharpe, lower drawdown as well; inflation is basically used as an excuse to convince this hypothetical client that she should move on the efficient frontier to a higher risk-adjusted return portfolio, given her young age. Sounds…familiar? Saving should be goal-driven but it is hard to envision which goal a “person in her late 20s” has to justify a 60/40 allocation in the first place. 100% stocks should be the default benchmark here. I understand that in the real world there are plenty of people that are not comfortable going all-in with stocks, but is this pseudo-CPI targeting the element that would make them accept the higher volatility portfolio?
Is CPI that big of a concern for a person that has plenty of time to grow her salary and it is already saving, so if something really bad happens can simply dial down her saving rate? What is sure is that her circumstances might dramatically change from one year to the other: she might find a partner and reduce her cost (couples spend way less than singles, especially in big cities), she might find a partner and get pregnant (higher costs, different CPI category), she might move country for her job (different CPI again), etc etc. Does a CPI-based plan improves her financial situation? I am not convinced.
This example reminded me of an ‘old’ episode of Animal Spirit Podcast: Where to Save for Your Down Payment. The episode is dated November 2021, still in the good old era of near-zero interest rates. A lot of investors were facing the dilemma of saving for a house down payment: keep your savings in cash and earn nothing or buy stocks with the risk to be in a severe drawdown by the time the sale closes. All the while house prices were rocketing up 20%. So a couple of brothers decided to launch the HOM ETF, a “risk parity like portfolio” that invest 60% in “bonds to control the downside”, 30% in stocks, with “half directly related to the housing industry, so if house values go up, the portfolio tracks that” and 10% in commodities to add diversification.
How did it go?
Imagine how bad must be your product if you got invited to the show one time against BlockFi’s Zak Prince …threes? fours? (yes, yes, I am JOKING…I know they have to pay to be on the show, they do not get invited).
Until someone invents the “give me rich parents so they can contribute to my down payment” portfolio/ETF/model, you are stuck only with bad options. I am sorry. This is not a diss about HOM, their portfolio might indeed hedge the down payment risk better than others, but the stated goal they gave to themselves is objectively impossible. [imagine if someone shifted from cash to HOM in 2021 and now sees their portfolio down 9% while cash is yielding 5%]
Let’s go back to Larry now (scroll up a bit to see his portfolio). Larry is in his late 50s and, bless him, approaching retirement. The Vanguard personalised portfolio is a no-brainer: higher return, lower vol, lower drawdown. This is clearly a better option, irrespective of whatever CPI circumstances the investor is in. The Vanguard exercise seems only to highlight the fact that the 60/40 portfolio is not part of the efficient frontier, that’s it.
I would think that at this point of his financial journey, Larry is more concerned with the sequence of return risk, how and if to glidepath his portfolio, max drawdowns and safe withdrawal rates. How his portfolio hedges CPI might come only after all those considerations. For example, if an allocation to commodities allows Larry to have a better projected safe withdrawal rate, I think he will go for it even if he is CPI over-hedged. 2022 is a great example: given the positive performance of commodities last year, do you think that any retiree would have been happier with a higher drawdown because he and his commodity-less portfolio were less exposed to CPI anyway?
Do you measure your personal inflation?
I do not. In the last two years, out of curiosity, I tried to pay more attention to our family expenses but I suspect the few data points that stayed in my mind are more noise than signal.
First, I think my time is spent better if I do something else than build an excel with our outflows; between me and my wife, we have 3 (main) accounts and 2 credit cards. Finding and learning how to use a no-code/light-code tool to automatize the process will not save me that much. There is a very good reason why I and my wife do not have a joint account: because it works for us. We both know where the money goes, in the grand scheme of things, but any deeper analysis would just create frustration, possibly conflict, instead of insight.
In three years we went from 0 to 2 kids. The concept of inflation is to compare the SAME basket of goods and services in different periods whereas we are constantly throwing away the past year’s basket and getting a new one. In other words, it is more relevant for our budget that we have to buy 3 airline tickets (and soon 4) instead of 2, not how much a single ticket increased in price.
We do not track expenses but we have a budget. And luckily that budget has some wiggle room, as our ‘standards’ are pretty flexible. Gone are the days of intercontinental flights for holidays twice per year, gone all the weekends visiting friends around Europe, gone the “it’s been the third time this week but we are tired so let’s order food”. We spend the same amount of money but on different things.
When you start to think about all these moving parts, you realise how hard it is to even create an index like the CPI. And how misleading can be to use it as a benchmark for your situation. I wish there was a way for me to call Oxford and say “hey, my daughter is coming in 16 years, can I already lock in part of the tuition today?”. Maybe I completely missed the point of the Vanguard paper but I do not think that’s the (rational) future of personal finance.
What I am reading now:
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