Investment Strategy in an Inflationary Environment

Abstract

This paper addresses the issue of how an investor concerned about the real rate of return on his investment portfolio should allocate his funds among four major asset classes: stocks, bonds, bills and commodity futures contracts. It employs the Markowitz mean-variance framework to derive estimates of the pre-tax, real risk-return tradeoff curve currently facing an investor in the U.S. capital markets. Some of the major findings are: 1) Bills are the cornerstone of any low-risk investment strategy. The minimum-risk portfolio has a mean real rate of return of zero and a standard deviation of about 1%. The slope of the tradeoff curve is initially 1, but it declines rapidly as one progresses up the curve to higher mean rates of return. 2) Stocks offer the highest mean and are also riskiest. 3) Bonds play a prominent part in portfolios which lie in the midsection of the tradeoff curve, although not much would be lost if these instruments were eliminated. 4) Commodity futures contracts are the only asset whose returns are positively correlated with inflation. By adding them to the portfolios of stocks, bonds and bills, it is possible to achieve any target mean real rate of return with less risk.