Bonds: The Perfect Inflation Hedge (with One BIG Caveat)

Mindy:
Welcome to the BiggerPockets Money Podcast show number 309, where we talked to Shane Shepherd from USC Business School about bonds, inflation, and rising interest rates.

Shane:
The primary form of bonds that most people invest in are these nominal bonds and, by and large, US Treasury bonds. Now, there’s also corporate bonds, right? That’s bonds which are issued not by the US government, but by a corporation. Those corporations typically have a little bit of what’s called credit risk associated with it, right? There’s a chance that these corporations might not pay you back. They could go bankrupt, and then you won’t get back your full amount that you’ve loaned to them. The greater amount of credit risk there is, the higher that yield you’ll receive will be. You’ll earn a higher interest rate for a lower grade credit bond than you would for a bond from the US government.

Mindy:
Hello, hello, hello. My name is Mindy Jensen and with me as always is my keen cohost, Scott Trench.

Scott:
I don’t know about keen, but I’m definitely heavily invested in the discussion today, Mindy.

Mindy:
You’re not invested at all in the discussion today. We’re talking about bonds.

Scott:
That’s right.

Mindy:
Scott and I are here to make financial independence less scary, less just for somebody else, to introduce you to every money story and every asset class, because we truly believe financial freedom is attainable for everyone, no matter when or where you are starting.

Scott:
That’s right. Whether you want to retire early and travel the world, go on to make big time investments in assets like real estate or fixed income, we’ll help you reach your financial goals and get money out of the way, so you can launch yourself towards those dreams.

Mindy:
Scott, I love today’s discussion with Shane Shepherd, a professor at USC Business School. He reached out to me when I said that we need somebody to talk to about bonds and he really delivered. We are talking about bonds today. We also bring up inflation and rising interest rates because they’re kind of all connected. Shane Shepherd is a full-time professor at USC Business School teaching investments and portfolio management. Bonds, rising interest rates, and inflation are the number one topics his students are asking about right now, and he reached out to offer his expertise and help us understand what’s going on and what may be about to go on in the economy. Shane, welcome to the BiggerPockets Money Podcast.

Shane:
Thank you. So happy to be here.

Mindy:
I am super excited to talk to you and thank you for reaching out, because I am on record as saying, I don’t like bonds. I am too young for bonds, even though I’m going to be 50 this year. I don’t like them because they haven’t in the last 20 years really performed very well. They haven’t given a lot off. All of a sudden, I bonds are all the rage. Everybody’s talking about them and how they’re yielding 9.62%, the last I heard. I love 9% yields on something so safe. Let’s talk about I bonds for a minute. What are they? Why are they paying so much? Should everybody drop everything and just go out and buy a ton of them right now?

Shane:
I bonds are a great topic and they’re certainly very attractive in today’s market. To start talking with them, we need to really understand the difference between a real return and a nominal return. If they’re giving us a 9.2% yield right now, that really is the nominal return, right? That is kind of what is your return in terms of actual dollars you’ll receive. And that’s what most people are used to thinking about. When we look at what they are in terms of a real return, it’s actually zero, right? Which is on one hand a lot better than what you can get from other bonds, and that’s why they’re so compelling and exciting right now. But the way an I bond will actually work is it’ll give you a stated real return.

Shane:
And if you bought one right now today, that stated real return is 0%. And then on top of that, they’ll pay you whatever the going inflation rate is. They’re a very natural and effective inflation hedge if I bought an I bond, which I have.

Scott:
Can you introduce the concept of real return?

Shane:
Yeah, sure. Your real return is your return after subtracting off inflation. In other words, if I earned let’s say 6% on the stock market, but inflation was at 9%, my real return is negative 3%. That is I’ve lost 3% in purchasing power. My dollars don’t go as far because of inflation. Real return, for most people, it’s important concept because that gets at what the growth in your purchasing power is. I bonds are a way that we can protect our purchasing power in terms of ensuring a 0% real return. What you’ll earn with an I bond is a 0% real return plus whatever the inflation rate is. You’ll earn… Right now if inflation is 9%, then I bonds are going to pay you 9%. If inflation drops down to 6% next year, those I bonds will pay you 6%.

Shane:
If inflation declines back to a normal steady state of 2%, those I bonds will quite quickly start paying you 2%. The actual interest you earn on those I bonds will go up or down with inflation, but your real return is always going to be sitting there at zero. In other words, what you’re really doing with an I bond is ensuring your purchasing power and not earning a real return. Your real return is just zero. Your nominal return will be whatever the inflation rate is.

Scott:
When people say that they’re really excited about this, they’re excited about getting a 0% real return.

Shane:
Yeah.

Scott:
Because they think everything else is terrible, right? That’s essentially what you’re saying if you’re really excited about I bonds, right?

Shane:
Yeah, that’s correct, but it’s actually not a bad thing to be excited about because it’s much better than the alternative if you look around at the competition. One natural point of comparison is what’s called TIPS, right? Treasury inflation-protected securities. Those are very similar to I bonds, but they’re actually traded on the exchanges. You could buy them on the open market. The real yield you get on those is about minus 1%, depending upon what maturity you’re looking at. But you’re basically paying money, you’re accepting a negative real return in order to get that inflation protection. I bonds are a great way to get that inflation protection without paying a cost.

Shane:
If investors are concerned with inflation, then investing in I bonds is a very effective way to actually hedge out that inflation risk without paying any kind of cost.

Scott:
Mechanically, how do I go about investing in I bonds? How much can I invest in I bonds?

Shane:
That’s exactly why this disparity exists, because the investment amount that you can put into them is severely restricted. An individual can put in up to $10,000 per year into I bonds. The Treasury has capped the amount at that. You buy them through TreasuryDirect. You actually need to go to the TreasuryDirect website and create an account with the US Treasury, and then you can purchase them through your account directly there. Now, the upshot is large institutional investors can’t effectively invest in those I bonds, right? Because the $10,000 limit is way too small for them to care about.

Shane:
That gap between that negative 1% real yield that a TIPS bond, where institutional investors are quite active, gives you and the 0% real return that you get from an I bond, that exists because institutions can’t invest in I bonds. It’s because of that $10,000 cap that individual are able to purchase them at what is a pretty attractive price compared to what the alternative would be.

Scott:
Great. If I’m an individual and I’m really worried about inflation and really don’t like any of the other alternatives, the I bonds are a great way to protect against inflation during inflationary times. Let me ask you this though, what happens in a deflationary environment to I bond yields?

Shane:
Yeah. That’s another nice feature to them, is that real yield won’t go below zero. If it’s a deflationary environment, you’ll earn a 0% real yield and then your purchasing power actually grows because with deflation, the cost of goods gets cheaper. You’re able to-

Scott:
You earn a 0% nominal yield?

Shane:
0% real yield is what the I bonds will give you if you buy them today.

Scott:
But in a deflationary environment, it would be flat.

Shane:
Right. Correct. Exactly.

Scott:
I’m making sure I understand. Okay, great. Who’s the ideal person to invest in these types of I bonds? Who should be using them?

Shane:
Who should care about this is people who are really concerned with and hurt by inflation, right? If you are an older retiree who doesn’t have kind of future income coming from work and you’re living off your investment portfolio, inflation is a really big risk for you, right? You might want to put a conservable amount or as much as you could into I bonds in order to earn that inflation protection or other inflation hedging assets, of which real estate, for example, is a prime candidate. People who wouldn’t necessarily want to invest in these is, I tell this to my students all the time, people that have a lot of future human capital, right? That is the assets that my students have as they graduate.

Shane:
The largest asset they have is their human capital. That is their future labor income. And that has a lot of natural inflation protection with it, right? That is as they go out in the workplace and grow and get promoted and start earning money, their wages will rise along with inflation. They should be much less concerned about inflation and less concerned about inflation protection. People on the other side of the spectrum, on the other hand, are the type who really should be looking for these opportunities to get as much inflation protection to their portfolios as they could.

Scott:
In the inflationary environment, just keep working and let your wages go up is kind of what-

Shane:
If you’re young, that’s great. If you’re retired, maybe not so much.

Mindy:
Yes. It’s not always your choice to continue working, Scott.

Scott:
Absolutely with that.

Mindy:
I bonds are currently yielding 9.62%. How long will that 9.62% stay there? Is it reset every month or week? How does that work?

Shane:
It’s every six months. They’ll pay out a coupon payment every six months, depending upon what inflation has been over the last six months. You’ll receive that payment and it’ll get adjusted with the inflation rate. If we’re sort of at peak inflation right now, which may or may not be the case, that seems to be a point of view people are talking about, then that 9.6% would be the highest that you would get from I bonds. And as inflation declines, you’ll get less than that six months from now and a little less six months later. If inflation continues to go up, if inflation went up to 12 or 15%, then you’ll earn that within the next six months.

Scott:
Let’s talk about this. We have I bonds as I think a tool in your portfolio. It could be really interesting to somebody who’s looking for… It’s not really a guaranteed return, but a high yield on a fairly safe investment, at least in the short run. It will definitely change with inflation over time, and the real yield is zero. You know you’re treading water, keeping pace with inflation. You’re not beating inflation, which I think is the goal of an investor, especially a younger investor, is to beat inflation to some degree over a long period of time. Let’s contrast that to the overall bond… Other types of bond investing and how we think about that as a tool in the portfolio.

Shane:
Yeah, that’s great. There’s a lot of different kinds of bonds out there that you could purchase. Probably the most common one we think of is US Treasury bonds. That’s a large portion of the market. If you’re an investor and you hold a fixed income ETF, like the BND ETF from Vanguard or AGG, for example, are two of the more popular ones you’re buying primarily Treasury bonds. Those are nominal Treasury bonds. That will give you a collection of bonds, which are issued by the US government at various maturities. When you think about what a bond is essentially, a bond is a loan, right? It’s a securitized loan. That’s an agreement from one party to pay a fixed rate of interest to another party for borrowing money.

Shane:
The government has agreed to borrow your money for a set period of time. In a short-term bond, it may be three months or six months or a year, or it could be a long period of time. It could be 10 years, 20 years, 30 years. There’s that fixed time period associated with this bond. There’ll be an interest rate associated with it. If you want to loan the US government money for one year, they’ll pay you roughly 1% today. If you want to loan it to them for 10 years, you’ll earn 3%, and you’ll earn that fixed rate of interest every single year. That’s why bonds are sometimes called fixed income. You’re in that fixed payment. The primary form of bonds that most people invest in are these nominal bonds and, by and large, US Treasury bonds.

Shane:
Now, there’s also corporate bonds, right? That’s bonds which are issued not by the US government, but by a corporation. Those corporations typically have a little bit of what’s called credit risk associated with it, right? That is there’s a chance that these corporations might not pay you back. They could go bankrupt, and then you won’t get back your full amount that you’ve loaned to them. The greater amount of credit risk there is, the higher that yield you’ll receive will be. You’ll earn a higher interest rate for a lower grade credit bond than you would for a bond from the US government. As investors think about looking at where to allocate to bonds, really what you want to do is compare.

Shane:
The big question is, what is that yield that I’m earning, that is kind of what’s my return going to be, and really how does that compare to the inflation rate is a great question, right? Purchasing a US Treasury bond, a nominal bond at even 3% today, with an inflation rate of 8%, 9% is definitely not a good deal, right? That implies a quite significantly negative real yield, where the income you earn from the bond is not keeping up with inflation. That really is a situation to avoid. The yields you’re getting on bonds today in that standpoint aren’t particularly compelling. I do think that situation hopefully is improving, right?

Shane:
While bonds have not been attractive for the last couple years, I think if interest rates are coming up, which they are, the Federal Reserve is meeting as we record this today and tomorrow to talk about the direction of future interest rates, as those interest rates come up and hopefully as inflation comes down, that yield situation can rectify itself. Bonds don’t have a compelling return in an environment where inflation is significantly higher than those yields. If we return to a more normal economic environment where they offer you a positive real yield with a yield higher than inflation, then there are benefits to holding bonds in your portfolio.

Mindy:
Who should be holding bonds in their portfolio? I’m going to be 50 this year and I hold zero bonds in my portfolio, because they don’t pay very much. I really like a higher return than 0% or negative percent. I really don’t like the negative percent. You just said they haven’t been attractive for a while. I’m starting to hear a lot more people talking about them. Why are people looking to them now because you just said they’re still not that great of a return? They kind of sound like they’re still a negative return except for the I bond, which you can only have $10,000 of. I mean, if you have a $10,000 portfolio, that’s a really awesome return right now.

Mindy:
But if you have a million dollar portfolio, I hate to be so blase, but what is $10,000 on a million dollar portfolio? That’s not really moving the needle very much. Do you know what I mean? Why are people starting to look at these now?

Shane:
I think, first of all, with the I bonds it is $10,000, that’s per individual. My wife and I both put $10,000 in. We’re steadily accumulating a position bit by bit. I think you can start acquiring it over time. Nominal bonds are looking at becoming more attractive, assuming that these interest rates go up. We’ve had a long period, since 2008 really, where nominal bonds had a very low yield, right? On the short end of the curve, we were pretty close to zero for much of the period between 2008 and 2020. They rose briefly in 2018 up to about 2%, but then they were cut down to zero once COVID came. But even if we have a 2% yield on a bond and inflation’s running it 2%, that’s not particularly compelling.

Shane:
You should ask yourself kind of, why do I want to hold bonds in my portfolio? I’d say really there’s two primary reasons. The first one is for income, right? That is we have steady fixed income. Traditionally, a lot of retirees would hold bonds in their portfolios. The old advice is your fixed income percentage you should look at compared to your age, right? Or your equity percentage should be a hundred minus your age, I guess. As you get older, you should add more fixed income into your portfolio. Retirees could have that steady fixed income and live off those bond coupons. They would know exactly what it is. It would match up to their expenses.

Shane:
Now, that gets considerably less compelling as interest rates decline and are so low and you’re not earning a very large yield on there. But the other reason to hold bonds in your portfolio is really for a diversification purpose, right? That’s something we talk a lot about in finance is the importance of diversification and, in particular, how will your portfolio hold up as we enter into let’s say an economic recession where the stock market may decline. That’s kind of where we are today. If you look at the return on the S&P 500 throughout 2022 so far, it’s down about 15%.

Shane:
Well, the idea is if that continues to go down and the economy does enter into a recession, the bond market should hold up much better. Bonds typically are a good hedging property against recession risk. In an economic recession, bonds will gain in value.

Scott:
Let’s talk about that, how bonds gain or rise or fall in equity value, bond equity value. Can you walk us through how that correlates with interest rates or in recessions, depressions, and bull economies?

Shane:
Yeah, sure. It’s best I think viewed through the lens of an opportunity cost, right? Right now you could buy a 10 year Treasury at 3%, right? That may not sound so good. But if we enter into a recession and the Fed decides, “Whoops! Inflation is no longer a concern. We want to try and reduce the cost of capital and get people back to work,” they may cut interest rates. And if a 10 year Treasury, all of a sudden, yields 1% or like it was in March 2020, the 10 year yield got down to 0.6%, now all of a sudden, having that 3% yield on your 10 year Treasury is actually a really attractive alternative, right? That’s a nice yield that you have that’s not available in the market once we hit that recessionary environment.

Shane:
People are willing to pay a large premium for a bond that’s earning 3% instead of the current bonds that would earn only 0.6%. That results in a large price appreciation to your bond. This is what you often hear. Bond prices rise as yields go down, right? In that environment, as the prevailing yield goes from 3% down to 0.6%, bond prices are going to go up significantly. That action of cutting interest rates as we enter in economic recession, the stock market typically will be down significantly and fixed income will rise, and that will offset the losses to your portfolio. You get more stability across your portfolio. The flip side there, of course, is true as well.

Shane:
If we lock in a 3% interest rate on a 10 year US Treasury today and inflation continues to run high and the Federal Reserve raises rates even further and we see inflation or interest rates at 6%, all of a sudden, that 3% payment on your 10 year Treasury is not all that attractive. The price on that investment you made will fall. You’ll end up with a capital loss on your portfolio from that bond exposure.

Mindy:
Okay. I have a question about the 10 Treasury, what you just said, because I’m confused. The I bond resets every six months. What I’m understanding you to say is if I buy a 10 year Treasury that has a 3% yield, then I get that 3% yield for 10 years? Is that what the 10 year Treasury means? And it doesn’t matter what interest rates do.

Shane:
Yeah, that’s correct. Look at it like this. If I lock in a 10 Treasury with a 3% payment, for a $10,000 bond, I’ll $300 a year on that. I’m guaranteed that $300 a year. I’m going to get that each and every year, right? That payment is fixed and certain. Now, the question is what’s the relative worth of that payment, right? Number one, kind of where is inflation? What’s the purchasing power of that fixed $300 payment I get? And then number two is the opportunity cost that is, could I do better if I could take my money out of that 3% 10 year bond and reinvest in a 6% 10 year bond? I could shift my portfolio to getting a $600 monthly payment. Clearly that’s better.

Shane:
And that reduces the value of that fixed 10 year bond if I were to buy or sell that in the market prior to the 10 year period of maturity being up.

Scott:
I have a question here about long-term yields and thinking about this as a lifelong investor, right? If you plot bond interest rates or yields over the last hundred years and you zoom into the last 40 years, you’re going to see that interest rates peaked in the late ’70s and early ’80s. They’ve really been on a long downward trajectory until 2020 and 2021 last year, when they were really at their lowest ever or approaching that. My worry, my fear is that those yields are likely to increase over the next 30, 40, 50 years on average relative to where they are today. And that because of that, any bond yields that I… If I were to lend money today, I could be lending more interest later and the equity value of those yields will actually decline.

Scott:
And that currently with yields on average lower than inflation, this is not a place for me to park my money. That’s why I have zero bonds in my personal portfolio. But again, I’m not an expert on this. How do you think about that particular framework with a long-term zoomed out lens?

Shane:
Yeah, no, I think your view is very valid, right? And that closely matches kind of how I manage my own portfolio as well with a relatively small exposure to fixed income today. I think the best way to think about it is you’re forecasting that interest rates potentially could rise going forwards and that is a risk. That’s certainly true. A lot of economic research has shown that the yield that you’ll earn on let’s say a 10 year bond is pretty well approximated by the inflation rate plus real economic growth, right? Why were bonds yielding 10 or 12% back in the early ’80s? Well, number one, we had very high inflation, and number two, we had strong economic growth.

Shane:
We’ve seen both of those factors decline ever since, and that’s led to that long-term down trend in yields that you talked about. We’re at the point today where we’ve got… I guess to kind of back up a couple years when we still had fairly low inflation, one and a half percent, and we had slower economic growth of about one and a half percent. That implies a sort of roughly 3% yield on your fixed income. You could look at that just as your guideline, right? If I’m going to invest in fixed income, I’ll currently today earn that. The bond market is telling you essentially, we’re forecasting… If it’s a 3% 10 year Treasury yield, the bond market is forecasting relatively low inflation over the next 10 years.

Shane:
Still a continuation of relatively slow economic growth, which is what the US has been experienced over the last 15 years. The idea is if you look at the information in the bond market, it’s not too concerned about inflation, right? It’s much less concerned about inflation than the average person. We can look at various signals from people’s willingness to pay for these fixed income yields. The information tells us that the bond market expectation for inflation is maybe two and a half to 3% over the next 10 years. Certainly high today, but declining and we’ll settle in on a long-term average of maybe slightly higher than we’ve been, but much, much lower. If that is the case, then a 10 year Treasury at 3% probably isn’t a bad deal if inflation settles back down to that.

Shane:
That said, I think you’re not earning a very compelling real return for most fixed income options right now. I think the main purpose for holding fixed income in your portfolio is really to stabilize the value of your portfolio as we go through the ups and downs in the economic cycle. Holding fixed income more as that hedge against a recession is probably the best use for that and best allocation. My advice would be keep an eye on interest rates. If they do come up to a point where you’re earning a more attractive real yield, then that’s the time to consider putting an allocation in. And also, you don’t need to look at… I’m kind of using this 10 year government Treasury as an example and that’s a pretty well-regarded benchmark.

Shane:
But you can invest in shorter maturity securities, right? If you wanted to invest in even a three year note today, you’ll learn something close to 3%. You could also invest in credit bonds, right? You don’t have to invest in bonds coming from the US government. You can pick up another percent or depending on how much credit risk you want to take another percent or more by loaning to corporations instead of to the US government. You could easily get your yield higher than that even. You could earn yourself a positive real yield from other types of bonds. That’s a reasonable way to put your allocation in place.

Shane:
Really I think the main point for buying bonds today is that stability, right, to offset that, not so much for the income and for a long-term yield. But that situation may change if inflation comes down and interest rates rise.

Scott:
Love it. It sounds like your high level approach is it’s not really that attractive of an investment vehicle right now, and it’s probably a smaller part of your portfolio for most long-term investors. But it does have a place to a certain degree and there’s lots of stability reasons to do it. Is that about that right?

Shane:
Yeah, that’s correct. Again, I don’t hold a whole lot of bonds in my portfolio right now and that’s exactly the reason why

Scott:
Awesome. When I think about 2022 from an asset class perspective, and we’ve had this discussion for the last six months, about where do you put your money, right? I can’t hold it in a bank account because I’m going to lose money to inflation. I’m going to lose value to inflation, which is sky high right now. The stock market is down 15%, and I don’t think lots of people are in shock about this because of the high valuations and the rising interest rates, which impact both stocks and real estate, right? You think real estate with rising interest rates is going be a challenge, right, although maybe offset by the fact that you think inflation’s going to spur higher rent growth to some degree.

Scott:
You think Bitcoin is a hard place to put a huge amount of your assets if you’re not really comfortable with volatility, right? Parking it all on gold is unattractive. How do you think about the overall portfolio management at this point in time following the discussion we just had on bonds?

Shane:
It’s a grim picture, right? And sort of what you’re asking for is a magical security that will give you a much higher return than anything else out there in the market.

Scott:
Well, let’s try the least bad security, instead of the magical one. Where’s the least bad place to put the money?

Shane:
Part of the trouble is they’re all kind of bad right now, right? That is if you think about it like this, as that interest rate on Treasuries come down, if you could earn seven, 8% on a Treasury today, that’d actually be pretty good, right? As that yield comes down, people start allocating money away from Treasuries over into things like the stock market. What does that do? That drives up prices in the stock market, right? Dividend yields on stocks come down, valuation ratios on the stocks go up. Stocks become a less compelling alternative. They start allocating more money into things like private equity or real estate as an alternative asset. All of these things start to get this what’s termed asset price inflation, right?

Shane:
And that’s been a result of kind of the Fed policy over the last 15 years of keeping interest rates extremely low. They’re trying to do that in order to push people out on that risk curve, to push people out of fixed income and into these other asset classes. As that’s occurred, we’ve seen the prospective returns in all these other asset classes also fall in tandem, right? I think this is exactly sort of a direct result of the low interest rate policy that we’ve seen from the Federal Reserve. Investors are right to think that, well, there’s not really that many great places to put my money. Where is the best place? I think the stock market should do okay in the long run. I’m concerned about valuations, for sure.

Shane:
One alternative is to move money out of the US markets and into kind of other developed market countries, and so kind of diversify your equity portfolio. There’s a documented thing called home bias where people within a particular country tend to invest the vast majority of their wealth in the equity markets of their own home country. That’s suboptimal.

Scott:
Certainly do.

Shane:
Yeah. There’s much higher… You can earn much higher dividend yield if you were to invest in the UK stock market or the German stock market, Japanese stock market. Diversifying abroad, overseas is actually a nice way to earn a little bit of a higher yield, diversify your exposures, and diversify your equity risk. That’s kind of one point that I would encourage people to look at. Alternative assets are kind of what’s been a big solution for a lot of institutions. That’s led to a lot of money flowing into things like private equity, private debt, real estate. This is the reason why we’re seeing a lot of institutional players come in and start buying up houses and pushing up prices in the residential real estate market.

Shane:
It’s because they don’t like bonds. It’s because they don’t like stocks. It’s because they don’t like the other alternatives. The impact there is as interest rates come down, the cap rate on real estate comes down in tandem. You’re seeing prices go up across the board. Real estate, I think, is still an attractive option. Prices certainly have skyrocketed in large part that’s because real estate is one of the best inflation hedges out there. You’re seeing a lot of people, institutions as well as individuals, look at acquiring real estate in a way to protect their portfolios against future inflation. I think that’s certainly on the institutional side a large part of the story behind what we’ve seen driving housing prices over the last couple years.

Scott:
Real estate in other countries are the two of the places to potentially think about diversifying into as part of a holistic portfolio approach is what I’m hearing there.

Shane:
I’d say that’s where most people are under diversified, right? Where they could look to incrementally move their portfolio. Now, certainly probably your listeners have a lot more real estate than the average person.

Scott:
This is a great discussion on diversification, right? If I am already a millionaire and have one, 1.5, $2 million portfolio that I’m looking to spread across very various asset classes, I think this is a great discussion. Let’s take off our millionaire hat and let’s put on the hat of somebody who is attempting to build their first $100,000 in wealth, right? They’ve just paid off their debts and they’re on this journey to financial independence. If you diversify too much in those early phases, you certainly protect your 50,000 bucks, but you also ensure that you go nowhere fast with that portfolio. How should someone in that situation think about investing? Is there a place to potentially think about getting aggressive for that maybe young and hungry investor who’s just getting started right now?

Shane:
Yeah, good question. Diversification has also been called a regret maximization policy. No matter what happens, you’re going to wish you did something different. It is I think a valuable framework, but you’re also not going to get the best possible outcome through diversification. I would say if you’re a young investor, you’re happy taking on more risk, you’ve got potentially a lot of future income coming in through work, then taking on risk in your individual portfolio is the right thing to do. Putting more money into equities, into fixed income, or sorry, into the housing market, doing things where you can sort of add value like through some of the things you talk about around kind of increasing housing value, that’s a really a nice way to increase the value of your portfolio.

Shane:
Certainly younger listeners should be willing to take on more risk and allocate primarily to equity markets and potentially things with more attractive long-term upside like the real estate market. Fixed income allocation to a younger investor should probably be pretty close to zero.

Mindy:
I want to put in a little asterisks next to your they should be willing to take on more risk. I would like to encourage people to do a lot of research before they invest in… When I hear risk, I think individual stocks as opposed to index funds. Index funds are the darling of the personal finance community and the early retirees. Have you read… Not Set Your Life. What’s Jim Collins’ book? Simple Path to Wealth?

Shane:
I have it. It’s on my list though. Yeah, I’m going to read it soon, I hope.

Mindy:
It’s a great book for people who don’t have… For people who want to set it and forget it. It’s a great book to explain how the index fund works. It’s a great book in a lot of ways. I don’t think that most people should be investing in individual stocks, even though I have invested in a lot of individual stocks. My husband is the one who is doing most of the investing into the individual stocks, and it’s because he is positively obsessed with tech stocks in general. He was a tech guy. He’s been reading tech news since the late ’90s. He wakes up and reads 50 different publications and all of their stories about Google and Facebook and Tesla and all these things all the time. He’s entrenched in it. And for that reason, I feel comfortable when he says, “Hey, I want to invest in this company.”

Mindy:
I know he is done a thousand hours of research last week on this thing. It’s a good… I don’t know. I can’t say it’s a good idea. It’s a well-researched idea, and we have a higher than average probability of success, the highest possible probability of success, because we have as much information as is publicly available. But I also want to say that if you don’t have the time, don’t just get a hot stock tip from some guy at Jamba Juice saying, “Oh, I heard that ABC company is going to go public next week and they’re going to be great.” That’s not the kind of investment that you should be doing. That’s not the kind of risk that you should be taking. Just because that might pan out doesn’t mean that every time you hear a hot stock tip at Starbucks, it’s going to pan out.

Mindy:
I just want to give a little bit of context with that risk. Yes, you can take more risk, but you shouldn’t be wildly investing, jumping in both feet without doing any sort of research and just hoping for the best because you’re 20 and that’s how it works.

Shane:
Yeah, no, that’s right. That’s good advice. More risk, I would say that means changing your asset allocation, right? Simple low cost passive ETFs is a great way for most people to invest. I think rule of thumb is keep your costs as low as possible, and that flows directly through to your bottom line. That’s the best way to go about doing it. And by taking on more risk, that just means allocating more towards higher volatility, higher return type of opportunities like a broad based US large cap ETF. The vast majority of academic evidence shows that people who try and choose individual stocks by and large earn lower returns. It’s not that they choose stocks poorly essentially.

Shane:
They choose stocks which earn the average market return on average. What they end up doing is trading too frequently and paying fees and commissions. Their broker gets rich. The individual doesn’t do any better, but they pay higher costs. The more aggressively somebody trades, kind of the worse their portfolio tends to do.

Scott:
Let’s think about this. You’ve got to… Let’s take a 1.5 million fantasy portfolio and let’s use a couple of cases here. We’ll probably have different portfolios, but let’s say I’m retirement age and I want this money to allow me to draw down $75,000 a year. I want to feel good, sleep well at night. What do I invest in?

Shane:
If you really want that security, if you want to avoid drawdowns, you need to have some fixed income in there, right? That’s the ballast in your portfolio that’ll offset kind of those drawdowns in the equity markets. It does depend upon kind of your age and time horizon, right, in terms of how much you need in there. But still, I would say kind of given today’s current yields and the outlook on the economy, if you were to be kind of 50-50 between equities and fixed income, that might be a reasonable I can sleep really well at night type of portfolio. I know I’ll get income. I know that my equities might experience draw downs, but over the long run, I should still experience that growth.

Shane:
If you’re looking at those as sort of your only two asset classes, that’s the reasonable approach. And then if you wanted to add other things into there, like real estate or whatnot, you could just sort of increase exposure to those and reduce your equity fixed income split pro rate.

Scott:
Awesome. What about if you’re 35-40 and have that same 1.5 million portfolio and want it to grow long-term, want to have the best outcome of having a big pile at 65? What are you doing then?

Shane:
It also depends upon if you’re continuing to work, right? So that is kind of your labor income is a big portion of this. For somebody who’s younger, labor income is a larger part of their wealth. Unless they’re planning on early retirement, and then you can sort of decide how many more years am I going to work, and then how much of that labor income represents compared to the value my portfolio. But if somebody’s willing to… They’re 35 and they’re willing to work until they’re 65, then that labor income is really large. That’s kind of a large offset. In that example, they could take on more risk with the equity portfolio, right? If you still want some security, you might push that to 80% equities, 20% fixed income.

Shane:
And if you are willing to take on… You could go even lower. I would say kind of in normal times, kind of 80-20 might be a reasonable split. It is conditional upon yields, right? Given how low yields are and how high inflation is right now, you might want to… I want to shy away from encouraging people to try and time the markets, right? But now is the time when we’re kind of at that inflection point. It may be a time where holding a little bit of cash is not necessarily terrible. You may have better opportunities going forwards. I don’t know if that’s the case or not. Certainly risk is high right now, right? There’s a lot of elevated risk in the economy. There’s a lot of elevated risk in the equity markets.

Shane:
And that’s sort of been played out over the last four months. It’s in those times when risk is rising and we’re seeing more volatility across what the future economy might look like. That’s a time when it might make sense to sort of add in a little cash to hedge that exposure and have some cash willing to redeploy to better investment opportunities in the future.

Mindy:
Okay. You said a little cash. Just a few days ago, Bill Bengen, the father, the inventor of the 4% rule, wrote into The Wall Street Journal and shared his current portfolio allocation. Bill Bengen is older than I am, but he said that his current portfolio allocation is 20% stocks, 10% bonds, and 70% cash. Far be it from me to question Bill Bengen. He is leaps and bound smarter than me. He is leaps and bound smarter than I ever will be. But Bill, I don’t agree with the 70% cash because our inflationary period that we’re in right now, his purchasing power is immediately being reduced every day that his money is sitting in cash, but he’s so uncomfortable with the markets in retirement that he’s violating his own rule. The 4% rule said 60% stocks, 40% bonds. I get that he’s uncomfortable.

Mindy:
Way back when COVID first happened, we had five retirees talk to us on episode 119, and the Mad Fientist, Brandon the Mad Fientist, came on and said, “I thought I was going to be able to weather any bounce in the markets. And as soon as the stocks dipped, I was freaking out, and I decided that I needed to take a step back and write down my feelings and not make any rash decisions,” because that’s the kind of person he is. I think it’s really helpful to hear somebody of Bill Bengen’s stature, somebody of the Mad Fientist’s stature understanding that it’s okay to kind of freak out when the markets are like this. But I would question the 70% cash.

Scott:
What do you have to believe, Shane, in order to move 70% of your personal portfolio into cash? What would be the set of assumptions you have to work under for that to be a viable approach for you?

Shane:
Yeah, that’s a great way to frame the question. It’s a really aggressive bet, right? It’s really aggressive bet on short-term market timing. I’d say the number one thing that you would need to believe is that you have the ability to execute a future plan, right? That is, he could be absolutely right that 70% cash is a good standing right now because we’re going to see the markets collapse as we enter in recession and inflation’s going to respond. But people could follow that advice and still be worse off, right? Because what you need to know is, when do I buy back in?

Shane:
What is my plan for buying back in? You got to be willing to say, “All right, well, the stock market just sold off another 30%. Am I going to buy now? Sold off another 40%. When do I step in? What if I’m wrong? What if the market goes up?” Let’s say that the market recovers and the economy seems to do okay from here on out, and we’re 15% higher six months from now. Am I still going to be sitting in cash? Am I going to buy back into the market? At what point am I able to admit, you know what, I was wrong and I need to go back and invest my cash into the equity markets. That’s really the big part is. I hear that sort of advice quite a lot. People oftentimes are taking a view on the markets and they may be right.

Shane:
But to actually execute on that and to know when to step back in and to be able to… Especially in the throes of a market downturn, it’s really difficult to step in and buy on the dip. People talk about it all the time. But who here was buying more equities in March of 2020? I’ll tell you, I wasn’t. It’s a hard thing to do. Scott’s raising his hand. It’s a hard thing to do, right?

Scott:
I think that’s where you come in and say, “What’s your plan,” right? I think that that has to be the answer. Hey, I’ve got the set of assumptions about the market. I think it’s going… If I’m going to put my position 70% into cash, I agree with you, inflation’s got to stop or there’s got to be deflation that I’m betting on because cash is better than the alternative in a deflationary environment than a lot of other things. I’ve got to believe that real estate prices are going to come down. I got to believe that rents are going to come down. I got to believe that the stock market prices are going to come down. I got to believe that bond yields are going to increase, interest rates are going to rise, right? All of those…

Scott:
That story has to largely be true or many aspects of it for me to move my position largely to cash, right? That’s not my plan. My plan is I believe that stocks over a 50 year period are likely to accrete value at some degrees. Sometimes there’ll be very high valuations. Sometimes there’ll be very low valuations. But when I look back as a 80 year old, 81 year old, 50 years from now, I will be like, “Great. I have more real and nominal wealth at this point in time because I invested in stocks than I do today.” COVID in March 2020 does not bother me, right?

Scott:
I was buying more during that period of time and just continuing to execute my plan of whatever my cash position gets over the level that I’m comfortable with, I sweep it and put it into the index fund or sweep it and put it into my next real estate purchase fund, right? And just continue that, just keep buying long, long-term approach with that, right? That’s my plan. There it is with that. But I think you got to believe some serious things are going to happen in order to move all to cash, what is likely millions and millions of dollars all to cash. And then, I love your ear point, have a plan to then harvest it in ways in what you believe is going to happen.

Shane:
Yeah, and having that discipline to execute on the plan, and then to also kind of know when to shift, right? That is if I’m wrong. I think that’s the bigger case, right? Because people get very stubborn and they say, “I’m moving all to cash, and I’m going to wait for the market to drop.” And then the market doesn’t drop and it goes up. And then it doesn’t drop and it goes up. At some point, you have to admit, “I was wrong and I have to change my plan now.” You want to think about that as well, not just, what am I going to do and when will I buy when the market crashes? That part’s easier, but kind of, what if I’m wrong? When will I admit I was wrong and shift my decision? That’s a big part of it too.

Scott:
We had Bill Bengen on BiggerPockets Money here on episode 153, if you want to go back and listen to that. I remember asking him on that. I asked him the same question we asked earlier today, we asked you earlier just a few moments ago of, hey, it looks like interest rates are likely to rise over the next 30, 40, 50 years, which is going to crush your bond equity in for that portion of your portfolio if you believe that, right? Stock market valuations are at all time highs, right? Inflation looks like it’s set to increase, right? All of those things. What do you do with your funds at that point? I’ll have to go back and listen, but I remember him kind of going, “I don’t know with that.”

Scott:
It’s kind of surprising to see that he’s doing that, but it’s also based on that reaction to our conversation that we had with him maybe last year or the year before, I think that was uncertainty that everyone is feeling, including the pioneer thought leader in this space.

Shane:
I think that’s right. One thing that we see people do is they tend to chase returns, right? That can be very dangerous. When things like the housing market is up 15, 20%, people tend to project that out into the future. They think, “Oh, it’s going to continue to appreciate at that level.” I remember in 2000 at the peak of the dot com bubble, surveys of investor expectations for future equity market returns were sitting in at 30, 40%. People just sort of imagined that was going to continue on forever. People tend to get excited by big returns. They tend to allocate towards those type of assets when they have big returns. They tend to get fearful when markets crash. That sort of market chasing behavior is really kind of productive, right?

Shane:
You’re much better off kind of having that discipline to systematically continue to invest, to view things as more favorable when prices are down and to kind of pause and be a little more trepidatious when asset prices are extremely high. That’s I think a good general rule. If you’re uncertain, we talked about where to invest with fixed income, one thing… Yes. If interest rates go up, you will see bond values fall considerably and kind of that principal on your bond will decline. But one solution to that is just keep your maturity short, right? I mean, if you’re buying short duration bonds, basically you lock up your money for a period of a year or two years and you can roll that over and reinvest.

Shane:
You’ll get your principal back, right? You’ll get your principal back once they mature, then you roll it over at a higher yield if interest rates go up. One solution towards kind of fear of rising interest rates is just kind of dial back that duration, invest in shorter duration bonds, shorter duration credit instruments, and then you can continually roll over and get that higher yield as yields go up.

Scott:
But I think there is… You do have to make an assumption at the end of the day about the long-term yields of the asset classes that you’re investing in, right? That is foundational to this of investing, right? The answer is nobody knows what’s going to happen over the next 50 years. Nobody knows what’s going to happen over the next 10. No one knows what’s going to happen over the next three. No one knows for sure what’s going to happen over the next five, right? Somebody will be right. You wonder if that’s a coin flip, or if it’s really skill that’s able to do that over a long period of time, right? But I will say that in 2000, to your point, they were saying, “Oh, the returns are going to be 20, 30% for the stock market forever.”

Scott:
We know that that’s crazy, but 2000 to 2021, we had a couple of big, big blips in that period, and the compound annual growth rate of the S&P 500 was 7.5% over even that period, which you can say may have not been the best period to invest in, right? I think it’s a… Long-term you can make an assumption about the return on equities or the return on bonds, right? The, thing with bonds or fixed income that you can make an assumption about is you know what the nominal yield is going to be, right? You don’t know what it’s going to be in equities, which I think is really the art of this.

Shane:
Yeah, that’s right. You can look at valuations and you want to think about, how do I position my portfolio given kind of the current opportunity set today? We talk a lot about asset allocation. Most asset allocation advice you hear is pretty static, right? That is, you’ve got single best strategic asset allocation may depend upon your age or demographics. And in reality, it should also depend upon the current market conditions, right? That is, as things get cheaper, you should want to put more into them, right? And as things get more expensive, you should try and sort of dial back that exposure. If you’re asking kind of what’s the long-term outlook, nobody knows for sure, right?

Shane:
But what we do know is those valuation ratios are actually pretty important. We could look at price to earnings on the equity markets, for example. You could look at cap rates in the housing market as a valuation tool. Those are good signals as to kind of the price you’re paying per dollar of earnings or per unit of income, or whatever it is. Just on average, if you follow a simple path of balanced allocation diversified with kind of a bit of sort of investing where things are cheap and not investing where things are expensive, that’s a long-term strategic plan.

Mindy:
I think it’s really easy to sit here and say, “Oh, you should just follow your plan. And when the stocks are on sale, you should buy more.” But it’s really hard to put that into practice. I wanted to bring up Bill Bengen’s current portfolio allocation because he’s Bill Bengen, and even he is having a hard time sticking to the plan based on the current… I mean, there’s a lot of things going on right now. I don’t know if you heard this, but there’s a war in Europe and we’ve got supply chain issues that aren’t going to work themselves out anytime soon. The housing prices are through the roof everywhere, no pun intended. There’s a lot of things that are going on. I think it’s really important to, number one, even have a plan that you’re trying to stick to.

Mindy:
I think a lot of people may not even have that plan in place. I want to make the most money ever. Well, so does everybody, but you also want to do that in the safest way possible. Sitting down with yourself or with your partner and creating kind of this living document, an investment plan, “What do I want in five years? I want to have this kind of asset allocation, or I want to have this sort of stability,” and looking at it in a bunch of different ways. But then also right now in this… It feels like a turning point. It feels like right now we’re on the brink of a big change in the investment space. Write down your feelings. I thought that was a really great tip from Brandon back on episode 119.

Mindy:
He said, “I’m not going to make any rash decisions right now. I’m going to write down what I’m feeling in the moment. So that when it passes, because I know it will pass, when it passes, I can go back and see what I was feeling and make adjustments to my overall plan. So that the next time this happens, because there will also be a next time, the next time this happens, I can learn from how I handled it last time and make a more holistic decision. Oh, okay, the market’s down. I’m going to ride it out. I’m just not going to look at the markets for a while, or I’m going to sell 10% of my things because they’re down, or I’m going to move things over into bonds, or however you’re going to handle it.

Mindy:
It’s not something you should make a… It’s not a decision you should make at the spur of the moment based on things that are happening.” I just recorded an episode of the show yesterday with my husband, because we’re talking about money, and I didn’t know that the market was down 15% because I’m not investing for tomorrow morning. I’m investing for 10 years from now, 15 years from now, 20 years from now. What it’s doing today, I don’t care about. I mean, I do care, but I don’t. I’m a worrier. I could really freak myself out if I watch the stock market all the time. I choose not to watch the stock market all the time because…

Mindy:
I don’t know how to say this without sounding so awful, but it doesn’t affect me today, so I don’t need to know what’s going on today. I’m not going to make any changes today based on my long-term plans.

Shane:
Yeah, that’s really good advice. I’ll refer to this. There’s a study that looked at people who owned or had money in a discount brokerage and kind of measured how frequently they logged into their accounts and then looked at their returns. What they found is that those people who logged in most frequently had the worst returns. The less frequently you log into your account, the better your performance was. The message is, number one, is it’s really you’re trading more frequently, right? Don’t trade. Don’t trade that frequently. You don’t even have to look at your account that often, right? What I recommend people do is keep track of things on a quarterly or semi-annual or annual basis.

Shane:
You should sort of look at your net worth and your portfolio value and, importantly, your asset allocation, right? See where that is on a regular basis. But for the most part, you don’t need to make frequent moves. And if you’re thinking about doing that, just remember the more often you trade on average, the worse your performance will be. I think if you have the ability to kind of lock that off and put it away and not think about it, that’s really the best investment advice.

Scott:
Weren’t the returns best in that study for folks who had died and not logged in at all? Something like that, to kind of emphasize your point there. We just said, going back a few minutes here, if I believe that inflation’s going to stop, that asset prices are going to come screaming down, and interest rates are going to rise, so that makes none of these investments fixed income debt stocks or real estate, for example, attractive to me, right? And then I go to cash and that makes sense if I believe that that is the forecast for the next couple of years. Let’s take another assessment though and say, what if I believe that inflation is likely to loom for some period of time and the Fed is unlikely to get it under control to a large degree, right?

Scott:
Well, in that case, wouldn’t the ideal bet be to borrow money on that front, because I’m going to be borrowing money today at one interest rate that’s going to increase later. And I believe that I’ll be able to pay it back with dollars that are cheaper in three, four, five years than they are today, right? Would that suggest, if I believe that, that I should not be paying down any of my debt and I should be, in fact, borrowing more against assets that I think will have inflation resistant income streams, for example, right? I don’t want to get in danger. I’m not going to do this in my own portfolio. I’m continuing to buy. I’m buying another rental property this year, like I am with my stock portfolio.

Scott:
I just continue to ply more assets into those as I generate surplus with this. Couldn’t you also take the extreme opposite opinion and say, “If I believe that, then the best thing I can do is go on a huge shopping spree and borrow as much as I possibly can against real estate, because I’m going to be paying that back with cheaper dollars downstream.” What’s your thought process on that?

Shane:
In an inflationary environment, really leveraged income producing real estate is one of the best assets out there. If you think about inflation, who does inflation hurt, right? Well, inflation hurts people who don’t have kind of labor income and are living on their fixed assets. Inflation is very bad for them because their returns are not keeping up with inflation. Those are primarily people who are saving and investing. Who does inflation hurt, or who does inflation help the most is the borrowers, right? Primary amongst that group is the US government as one of the largest borrowers that’s out there. Well, inflation’s really good if you’re issuing trillions of dollars in debt, right? You can pay it back with dollars in the future, which are worth less.

Shane:
Investors, if they think there’s going to be continued inflation, which is certainly a plausible outcome, then one of the best things to do is lock in a lower long-term fixed rate mortgage. Even at 5%, that’s still relatively low compared to what future inflation might be. Real estate. I think the best way to look at inflation in real estate and real estate appreciation is in the long run, real estate should… The value real estate should grow along with the inflation rate, right? That’s sort of a more or less one for one pass through. If inflation goes up 8%, we might expect real estate to go up 8%. And that’s because you expect rents to go up 8%, right? Shelter or rents or owner applied rents, that’s about 30% of CPI.

Shane:
That is the single largest component of CPI. When we say inflation’s up, a big part of what we’re saying is, “Yeah, rents are up.” That’s a big proportion of it. Investing in real estate, you get that inflation protection, right? Number one. You’ll have those rents rise along with inflation over the long run. You’re less concerned about inflation. And then number two, if you’re to take out a mortgage, that inflation is going to eat away the value of that debt that you have. That’s a big reason why I think we’ve seen such a huge surge in the housing market over the last year and a half is with the spectrum of rising inflation, people are sort of trying to get ahead of the curve on that and push those prices up even faster than the inflation rate.

Shane:
That said, I think the housing market should probably just more or less keep up with inflation going forwards, which is a good thing, right? That’s probably all you need to ask for. And then if you’re able to pay back your loan with dollars worth less in the future, that’s in a higher inflation environment certainly one of the most attractive options that’s out there.

Scott:
What I believe is going to happen, just to kind of put a bow on this, and I think about it is, is I believe inflation is likely to stay at a relatively higher rate. I believe interest rates are likely to rise. I believe that that rising interest rates are going to mute the growth of the stock market and real estate. But I believe that for the first time in 10 years, we’re already seeing this this year, rents are going to start rising much faster than home price appreciation across the country. To me, that’s where I continue to have more assets in real estate than stocks, but I’m leveraged in there with that as a bet. And then I have the stock market. I have my cash position.

Scott:
I have a larger cash position, and I split that cash position across both cash and gold, because I believe that gold will hold its value a little better in an inflationary environment than dollars will. But I consider those are my currencies, for example. And then obviously I have some other things going on, like BiggerPockets as a business that I participate and are shipped with, and then a couple other things like private investments. But that’s what I believe and what I’m doing. I believe that those are the right calls over a very long period of time, right? Things would have to change foundationally about the economy for me to believe something different, for example.

Shane:
Yeah. Right. Starting with that, rents should I think outpace housing prices because housing prices have outpaced rent by such a large extent over the last year. Rents will have to catch up. We’ll see that happen. Inflation, I’ll say the market’s expectation is that it’ll settle back down to a manageable level, so probably higher than the 2% we’ve become accustomed to, but certainly below. It depends on what you look at, right? If you looked at kind of the core CPI, right? You’re taking out food and energy, which are kind of very volatile, that’s sitting at six and a half percent.

Scott:
I agree with that. I don’t think inflation’s going to loom at like 10% a year for a long period of time. Just higher than 2%, but not 9%.

Shane:
It’s interesting if you look at kind of what’s been causing inflation, right? There’s really three primary things that have led to this inflation environment we in right now. Number one, low interest rates and I think that gets kind of a lot of the blame in today’s discussion. Very low interest rate policy from the Federal Reserve. Number two is supply chain shortages. That’s certainly been part of the story, particularly in semiconductors or I think timber was a big example of that earlier on, that we’ve got shortages in the supply market. Number three is fiscal policy. I think it’s actually that third one which has been the biggest culprit in terms of inflation. There’s a paper that the San Francisco Federal Reserve published not too long ago.

Shane:
They sort of tried to back out these numbers and sort of put forth that 3% of the inflation surge that we’re seeing is been caused by that CARES Act and the American Recovery Plan. Those two big fiscal payments that we saw, and that they’ve led to a 10% for the first one and 15% for the second increase in personal consumption, right? That is money that we’re putting directly into people’s pockets to go out and spend. And that’s been responsible for roughly 3% of the inflationary surge that we’ve seen. That’s the fiscal spending. Supply chain management is another thing that may be solved more quickly or not, that may be more ongoing. And then we got the federal interest rate policy starting to come up.

Shane:
When we look at those causes of inflation, you want to ask to think about inflation going forwards, how are those changing? The fiscal policy does depend a lot on what Congress decides to pass and what we as voters sort of are going to be willing to accept. I don’t think we’ll see the same size of fiscal spending going forward as what we’ve seen as a result of the pandemic spending. This is sort of the Federal Reserve’s policy when they talked about inflation being transitory, that these are the things they were looking at. They were saying, “Well, it’s largely fiscal spending, and that’s going to get dialed back, and it’s the supply chain issues, and that’s going to get rectified. Once those things kind of get back to normal, then inflation should take care of itself, right?”

Shane:
This is their story 12 months ago. That’s proved to not entirely be the case that. Mostly these things haven’t unwound as quickly. They’re starting to raise interest rates to do what they can to combat inflation. I think the low interest rate policy hasn’t been a big driver of inflation. If you look at it, we’ve had the Fed Funds Rate at close to zero for the better part of 15 years, right? Now, how much inflation do we have from 2009 through 2018? It wasn’t large. It wasn’t much. If it’s low interest rates that are causing inflation, why didn’t it happen earlier?

Scott:
Well, we had a great discussion with Tom Honig on this, former president of the Kansas City Fed. He had a great discussion where the inflation… There’s two types of inflation according to him, where you’ve got asset inflation and you’ve got CPI inflation. CPI does not measure asset inflation. When you reduce interest rates and you allow that kind of borrowing to take place, that cheap money, what that did is that inflated the asset prices of homes, real estate, stocks, private equity investments, those types of things. And that that has been a major driver of the phenomenal returns we’ve seen over the last 10, 15 years, well, 10, 12 years, in a lot of those asset classes.

Scott:
And that is kind of the story of the inflation there. There’s that trickle down theory where now to keep driving those returns, that’s kind of beginning to flow downstream. You wonder if there’s longer term levers as a result of that policy that will take some time to unwind to some degree.

Shane:
Yeah, that’s right. That goes back to what we were talking about earlier with kind of as interest rates have come down, the Fed’s trying to encourage people to move out on the risk curve and take money out of bonds and into stocks, into real estate, into the other alternative asset classes. As bond yields have come down, we’ve seen dividend yields come down. We’ve seen cap rates come down. That is asset price inflation. The big question now is that reversing as interest rates come up. Are we going to see this asset price decline as a result of interest rate policy. Essentially in order for that to happen, that means people are going to allocate out of those other assets and back into fixed income, right?

Shane:
You got to say, “Oh, well, now that bond yields are at 3%, 4%, I’m happy to hold them again.” It remains to be seen how eager people will be to jump into the fixed income market, particularly with inflation. Inflation is the big question. If inflation settles in back to two to 3%, you can earn five to 6% on interest rates. That’s not bad. I think you probably will see a large scale reallocation back into the fixed income markets. As a result, you’ll see dividend yield on equities come back up. You’ll see cap rates in real estate head up a little bit. That’s the risk. That’s the view on if you want to keep a lot of cash on hand. You’re sort of playing that angle of it, right? That interest rates will come up. You’ll see asset prices come down. I’ll get bargains in the future and inflation won’t be too bad.

Scott:
Shane, before we wrap up, how would Mindy and I do in your class? Would we be on track for an A, a B, a C? How would we do as one of your students here?

Shane:
Yeah. Well, I’ve got a final exam tomorrow, in fact, for one of my classes. You’re welcome to come sit in and take it and I’ll see how you do. Give you a grade.

Scott:
Maybe we will.

Mindy:
No.

Scott:
Be careful.

Mindy:
I have been out of school for a long time on purpose. Scott, you’re welcome to though. Go now.

Scott:
This has been a phenomenal discussion. I think at the end of the day, we had a really good discussion. You’re incredibly well-informed and know this market and all these concepts really, really well. By the end of the day, we just don’t know what things are going to happen on a go forward basis. It’s all a matter of what you believe and what your plan is. I love that. I think that’s the big thing is have a plan and know what execution or good execution of it looks like. We’ll continue to have lots of good conversations about this topic and think it through. Who knows who’s going to be right or what the outcome’s going to be in a few years across these asset classes?

Shane:
In that regard, I think people like to talk about returns and kind of what asset class or opportunity will give me the best return. It’s a very obvious number that people like to think about. But as you’re saying, it’s really just so uncertain and it’s very difficult to predict. I think most people are better served by not thinking so much about returns and thinking a lot more about risk management and sort of planning for different outcomes. What might happen in this scenario? What might happen in that scenario? How can I make decisions that will leave me well enough off regardless of what happens in the future? Diversification is a big part of that, right? But trying to assess that from a risk management standpoint rather than a which asset class will give me the best return framework.

Scott:
Well, Shane, where can people find out more about you?

Shane:
I’ve got LinkedIn account is probably the primary place. I’m not very active on social media, or my webpage at the USC Business School.

Scott:
Absolutely. You can find those at biggerpockets.com/moneyshow309. Shane, thank you so much for the wonderful discussion today across a wide ranging variety of subjects, but in particular, bringing your expertise on bonds and fixed income, which is something we I think have a lot to learn about, Mindy and I, on the Money Show here. We really appreciate it.

Shane:
Thank you. My pleasure. Happy to do it.

Mindy:
Thank you, Shane, and we’ll talk to you soon. Okay, Scott, that was Shane Shepherd and that was an awesome episode. What did you think of the show?

Scott:
I thought it was great. I think it was a good chance to learn more about fixed income and investing in bonds. I think that at the end of the day, there’s still not for me right now. The set of assumptions that I have to believe long-term about bonds don’t work for my portfolio. I think it was reaffirming to a certain extent for that, but I can see where and when they will have a use case in my portfolio. That opinion will revise if, for example, yields get really high, like in the eight to 10 to 12, 15% range, and it looks like there will be a period where yields will begin declining long-term. That would be a great time to be a lender on a fixed straight loan of 10, 12, 15% if that circumstance could happen and inflation’s going to come down.

Scott:
There could well be a time when bonds become a major part of my portfolio, but it would just be something that I’d have to believe about the future, and I don’t currently believe that.

Mindy:
I agree. Bonds… After having the conversation, I did go in with an open mind. I wanted to hear about the bonds. I feel like I understand them more after speaking with Shane, but I still agree with you. They’re not part of my investment plan. I think they have a great purpose for a lot of people. I’m just not in the position right now where I want to be investing in bonds. Again, that might change in the future. I’m sure it will change in the future as I get a lot older, but right now I still want to be generating wealth. I’m in different asset classes.

Scott:
Now, the inflation, the I bonds, those make sense. I probably will put the $10,000 per year into the I bonds based on this discussion.

Mindy:
Per person.

Scott:
Because why park it in cash when I can get a 9.62% yield, right? And then if there’s a deflationary event, the yields go to zero. It’s the same as having cash in that particular case. It seems like there is a good use case for that, and it could be valuable for somebody who is looking for a safe place to get some yield in the short run.

Mindy:
Yes, and that is per person, so you and your wife could each have $10,000 in I bonds.

Scott:
Awesome. Well, it sounds like I owe you $962 worth of beers for that tip.

Mindy:
Oh, I love that. Okay, let me see if I can get you some more tips then.

Scott:
For those tips. Oh, is that a pun? All right. Should we get out of here, Mindy?

Mindy:
Yes, we should. I’ll take credit for the pun, but it wasn’t a pun.

Scott:
Disclosure. TIPS are separate from I bonds. We’re not completing the two, but yeah.

Mindy:
From episode 309 of the BiggerPockets Money Podcast, he is Scott Trench and I am Mindy Jensen saying thanks for the chat, cat.