Planning Q&A: Inflation, Forward-Looking Returns and the Planning Process


Michael Santelli, CFA, Director, Portfolio Manager
Vanessa Mavec King, CFP®, Senior Vice President, Financial Planning

With inflation running well above normal and forward-looking returns having moderated, we discuss how this backdrop impacts the wealth planning process and financial readiness levels.

Q: Vanessa, can you please explain the role that inflation, volatility and future expected returns play in the planning process?

When we take clients through the financial planning process, there are many variables that are considered. First and foremost, what are the client’s goals and, then, what are the assets in place to support those goals. Once those items are outlined, other variables such as market returns, volatility and inflation play a major role in the health of a financial plan. Inflation affects the buying power of the clients’ assets over time and, because of that, can impact their ability to afford their goals. In any environment, but especially in an inflationary one, market returns and asset allocation become increasingly important.

Market returns will need to be at or above inflation to keep pace with purchasing power over the course of the client’s plan. However, as we know and are currently seeing, market behavior is not static or always predictable. There will always be volatility in the market and not every year will see a positive return. That is why time is such a powerful component of investing and planning. Our advice and strategy for a plan will depend heavily on where that client is in life, how soon will assets be needed to fund their lifestyle, what kind of volatility they are comfortable with and what kind of volatility they can afford.

Historically, staying invested through the volatile times is the best way to continue to keep pace with and beat inflation over the long term. At the end of the day, all of this culminates with cash flows and stress testing a client’s portfolio for the not-so-good times. We do this by using a Monte Carlo analysis that looks at 1,000 different sequences of return opportunities over a given lifetime and analyzes if a portfolio is set up to withstand unforeseen or unfavorable inflation, market returns and volatile periods.

Q: Michael, Ancora just completed its periodic update of capital market return and inflation expectations. In general, can you provide a little color on those expectations?

We analyze forward-looking expected returns by using a framework of building blocks. Returns can be broken down into three basic components: income, growth, and multiple expansion/contraction.

  1. With fixed income, the first component, income, will provide basically all the return. With equities, we integrate all the components. The income component is the dividend yield plus a normalized buyback yield to account for stock buybacks.
  2. The growth component consists of real earnings growth above inflation plus the inflation component since we believe, in aggregate, that earnings should keep pace with nominal economic growth.
  3. The final component, multiple expansion/contraction, explains most of the volatility in year-to-year returns. For our planning purposes and assuming a long-time horizon, current valuation levels represent a small headwind to future returns, so some mean reversion from a multiple standpoint is likely.

For 2021, our long-term return assumptions for planning purposes were generally a bit lower than for 2020, considering the multiple expansion that occurred in 2021 after the stock market posted very high returns.

Q: Vanessa, given the outcomes Michael just outlined, what on the planning side are some steps to consider as investors seek to maximize their financial readiness score?

Market environments like the one we are in right now can be stressful, but reactionary decisions often do not serve a long-term plan well. To maximize both your comfort level and your financial readiness score, it could be helpful to start by simply revisiting your cash flow assumptions. The most critical part of anyone’s plan is relative spending. What items are most important, which could wait, are there dollars that can be used in more efficient ways etc. As you review cash out flows, consider ways to be strategic and cut back on spending in areas where inflation is especially high right now. Also, if you have existing loans, perhaps consider refinancing or paying them off while rates are still favorable.

On the investment side of the financial planning equation, ensuring you have an asset allocation that suits your current lifestyle will serve you well. Look at what you currently own in your portfolio and determine what drives those different asset classes. In some cases, it might make sense to consider some alternative investment classes that work well against high inflation, like commodities often do. During inflationary periods, one of the most vulnerable places your money can be is in cash because, as inflation ticks up, the value of your cash declines.

Of course, we always suggest keeping some immediate liquidity of cash set aside for short term needs, but if more than that is set aside, consider whether it could be put to better use. It can be tempting to try to time the market but staying invested in your long-term equity holdings historically is one of the best ways to fight inflation, even if it’s tempting to get out when there is so much volatility.

Q: Michael, on the investment side, how should investors be thinking about asset allocation in your opinion, considering the potential for lower returns?

The first variable to think about is risk tolerance. We work hard to find an appropriate asset allocation for each client where they are taking enough risk to generate attractive long-term returns, but not too much where they cannot sleep at night if the market hits some turbulence. Staying invested is critical to long term success, so the likelihood of bailing out at the wrong time needs to be minimized. The only person that gets hurt riding the rollercoaster is the one who unbuckles in the middle of the ride. We work to create an appropriate allocation for each client, so they stay “buckled in. “

Q: We all know the importance of thinking long-term, but in times like these it can be more difficult. Any tips or words of advice on how to make staying focused on the long term easier to do?

Vanessa: Obviously I may be biased, but I feel that having a financial plan, or creating one you are comfortable with, is the first and most important step. Once you have a plan, you can always edit and stress test the assumptions. I would then emphasize that you should trust the plan.

It is also helpful to understand your expenses and acknowledge which are truly fixed and which you consider discretionary. Alongside cash needs, discuss and implement a diversified approach to investing, that you understand and are comfortable with, without trying to time the market. Most importantly, recognize your time horizon. Like anything in life, there are uncomfortable periods, but know that your goals and the tools you have in place to achieve them are built on long-term planning.

Michael: I would stress again the importance of building a portfolio with an appropriate amount of risk. As Barry Ritholtz, an industry veteran, says (which we’ve paraphrased), The best portfolio is not the one with the highest returns. The best portfolio is the one our client can live with. I would also agree with Vanessa. The financial plan is the true benchmark for each client. It’s not the S&P 500 or any other financial market benchmark. Success should not be defined as “I beat the S&P 500”. Success is the ability to meet the goals you set.

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