Inflation-Protecting Asset Allocation: A Downside Risk Analysis

Abstract

This article studies the inflation-protection qualities of cash, bonds, stocks, and direct real estate, and the optimal inflation-protecting asset allocations within a downside risk framework. Using a value-at-risk model to capture predictable price dynamics, the authors find that the inflation-hedging properties of assets substantially change over the investment horizon. Cash is clearly the best hedge against inflation in the short run. However, as the investment horizon increases, bonds, stocks, and real estate become the more attractive options, with real estate exhibiting the best inflation-protection qualities on a medium- and long-term basis. While cash plays the most important role in short-term portfolios, the weights of the inflation-protecting portfolios shift to real estate, stocks, and bonds as the investment horizon increases.