In times of rising inflation, an investor with a balanced portfolio consisting of both equities and bonds will note a rise in performance of the bond side of the portfolio and a decline in the performance of the equity side. This is another important reason that you should invest in a basket of securities that are diversified across asset classes. Bonds protect your portfolio from inflation risk, especially if inflation-protected government bonds are included in the mix. In fact, in time of very high spikes in volatility, inflation-protected bonds are the only element of a portfolio that may do well.
It is important to note this basic economic principle as an academic matter because many of today’s investors have never lived (or at least invested) during a time of high inflation. We hope that the FOMC has risen in sophistication to a level that it can prevent the terrible economic conditions that prevailed during the Carter Administration from ever happening again, but we will not know if it can happen until it does. As I will argue in the final chapter, a well-designed portfolio will have hedges against all types of risk.
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