Inflation: An Exchange Between Eugene Fama and David Booth


With the economy starting to recover from the COVID-19 pandemic and investor concerns turning increasingly toward inflation, Dimensional Founder David Booth talked with Nobel laureate Eugene Fama about inflation and how investors should think about it in their portfolios. Excerpts from their conversation have been edited for clarity.


On Predicting Inflation

David Booth: Gene, you are a founding Director of Dimensional and have been involved in our research and corporate governance for more than 40 years. People may not know that you’ve also done a lot of research on inflation and interest rates.

We always tell people, “We don’t try to forecast. We try to be prepared for various outcomes.” Inflation is one of those things you want to be prepared for. There’s a pickup in inflation risk that wasn’t there, say, 10 years ago. Does that cause you to worry?

Eugene Fama: Historically what’s happened is, when there’s a spike, the spike persists for a long time. Inflation tends to be highly persistent once you get it. Once it goes down, it tends to be highly persistent on the downside. You’ve got to be prepared for that. Predicting next month’s inflation may not be very hard because this month’s inflation can be a pretty good predictor of next month’s inflation, or next quarter’s inflation, or even the next six months’ inflation. Persistence is a characteristic of inflation.

We haven’t been in a period of high inflation, or even moderate inflation, for at least 10 years, so I’m not particularly concerned that inflation will be high soon.


On How Investors Should Think About Inflation and Their Financial Goals

Booth: Conditions change, so is there anything about the current environment and the risk of inflation heating up that would cause you to change your portfolio?

Fama: I don’t think anybody predicts the market very well. Market timing is risky in the sense that you’ve always emphasized: You may be out of the stock market at precisely the time when it generates its biggest returns. The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.

I think you take a long-term perspective. You decide how much risk you’re willing to take, and then you choose a mix of bonds, stocks, Treasury Inflation-Protected Securities, and whatever else satisfies your long-term goals. And you forget about the short term. Maybe you rebalance occasionally because the weights can get out of whack, but you don’t try to time the market in any way, shape, or form. It’s a losing proposition.

Booth: As you get to the point in life where you actually need to use your portfolio, does that change the kinds of allocations you’d want?

Fama: The classic answer to that was, yes, you’d shift more toward short-term hedges, short-term bonds. Once you had enough accumulated wealth that you thought you could make it through retirement, you’d want to hedge away any uncertainty that might disturb that. That’s a matter of taste and your willingness to take risk and your plans for the people you will leave behind, like your charities or your kids. All of that will influence how you make that decision. But the typical person who thinks they’ll spend all their money before they die probably wants to move into less risky stuff as they approach retirement.

Booth: The notion of risk is pretty fuzzy. For example, if I decide that I want to hold Treasury bills or CDs when I retire, and you did that 40 years ago, when we started the firm, and you’ve got that 15% coupon, that’s pretty exciting. With $1 million at 15%, you’re getting $150,000 a year. Today you might get less than 1%.

Fama: Right, but I remember when inflation was running at about 15%, so not much better off!

Booth: Those are different kinds of risks.

Fama: When you approach retirement, you’re basically concerned about what your real wealth will look like over the period of your retirement, and you have some incentives to hedge against that. You face the possibility, for example, that if you invest in stocks, you have a higher expected return, but you may lose 30% in a year and that might be devastating for your long-term consumption.

Booth: I think part of planning is not only your investment portfolio, but what to do if you experience unexpected events of any kind. We’re kind of back to where we start our usual conversation: “Control what you can control.” You can’t control markets. What you can do is prepare yourself for what you’ll do in case bad events happen. Inflation is just one of many risk factors long-term investors need to be prepared for.

 

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