With inflation a meaningful economic factor after a decades-long hiatus in many countries, households need no tutorial on its impact on their day-to-day spending, as budgets are stretched thin by sharply rising prices.
Yet investors typically aren’t aware of how a high inflation rate can be a drag on their portfolios, suggests research by Goethe University Frankfurt’s Philip Schnorpfeil (a postdoctoral scholar), Chicago Booth’s Michael Weber, and Goethe’s Andreas Hackethal. (They aren’t aware of how inflation lowers their debt either. For more, read “For consumers, inflation has an upside.”)
The researchers conducted a survey of about 2,800 clients of a German bank in February 2022, when Germany’s inflation rate hit a 30-year high of 5.3 percent. Respondents—all of whom had an active portfolio that included at least mutual funds—were asked to weigh in on their sense of how inflation affects the expected return of distinct asset classes.
The survey uncovered a lack of clarity on the relationship between high inflation and market returns. About half of respondents estimated that nominal returns for the German stock market would be lower during periods of high inflation, and nearly 40 percent expected higher returns. In fact, German stocks have underperformed when inflation is high in Germany. That’s a trend common in other countries as well: stock returns in general are lower when inflation runs hot.
Although many respondents correctly estimated long-term returns in general, as well as the historic and current rates of inflation, they didn’t initially understand how high inflation affects the return potential of specific asset classes. For example, while stocks in general have lower returns during periods of high inflation, international diversification can provide better returns during these periods, assuming the countries being invested in aren’t going through their own inflation battle. Meanwhile, the prices of commodities including gold tend to spike. When the researchers provided information about these types of relationships, the respondents updated their expectations and their portfolios.
The researchers shared with some respondents the actual returns for these asset classes during the five periods of high German inflation (4 percent or more) since 1950. Another set of respondents got these same data, as well as a narrative explanation of what factors drove those returns.
Survey respondents given detailed information about how past inflation affected asset performance made larger adjustments to a €10,000 portfolio—by reducing investments in German stocks and increasing allocations to gold and international stocks—than those only told that current inflation was high.
Compared with a control group that received no additional information, both the group that was given historical data and the group that got those data and an explanation changed their return expectations accordingly in follow-up questions. On average, respondents who learned about the historic impact of inflation reduced their 12-month-return expectations by 1 percentage point. The group given both the data and some contextual explanation had the biggest response.
The researchers also find that respondents who had the most optimistic expectations at the start of the study made the biggest adjustments to their return expectations after they had digested the data.
When respondents were asked how they would allocate a €10,000 portfolio in a period of high German inflation, they again incorporated their learning into their portfolio construction. Those who had been shown the historical data allocated €832 less to German stocks than the control group, and plunked down €383 more in gold than the control group, suggesting they had digested the history lesson. Once again, respondents given the data and some explication were even more responsive to the new information, opting for a German stock allocation that was nearly €1,300 less than the control group and making far bigger bets on Japanese stocks (+€522) and gold (+€457).
To see how this played out in the real world, the researchers tracked the trading activity of German stocks among respondents in the two, four, and six months following the initial survey. The inflation rate spiked above 11 percent in that six-month window. Net purchases of German stocks by respondents who were given data and text descriptions of how high inflation had historically affected asset class were about one-third lower, on average, than they were three months prior to the survey and compared with traders who had not received any information during the survey.
“We find investors are well-informed and concerned about inflation, yet seem largely unaware of how to protect against it,” Schnorpfeil, Weber, and Hackethal write. A simple intervention—a quick lesson using historical data—helps address that shortcoming.
Philip Schnorpfeil, Michael Weber, and Andreas Hackethal, “Inflation and Trading,” Working paper, May 2024.
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