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Arnott: Are 401(k) Investors Fighting Yesterday

Arnott: Are 401(k) Investors Fighting Yesterday's War?


  1. Inflation-fighting assets such as TIPS, REITs, and commodities should be blended into the portfolio in a meaningful way.
  2. Non-dollar assets should be used on a scale large enough to protect against any government choices that may debase the dollar. Of course, Japan and Europe face the same “3-D Hurricane” that we face here, only more so. So, these non-dollar investments should be in the emerging markets, in the local currencies. It bears mention that the emerging markets largely shrugged off the “global financial crisis” and the “great recession.” Why? Most did not have massive debt. Most did not respond to the crisis with massive deficit spending and new debt. And most chose to let failing enterprises fail instead of propping them up.
  3. There should be investments in inflation “stealth fighters” such as high-yield bonds, bank loans, convertibles, and local currency emerging markets debt.10 Inflation stealth fighters work in a subtle way. Inflation reduces the real value of the debts, improving debt coverage ratios. As the coverage ratios improve, the credit spread can narrow creating capital gains on top of the original rich yields. This leads to startlingly high correlations between their returns and the rate of inflation.
  4. Tactical allocations among the asset class choices. Higher inflation breeds volatility which, in turn, breeds opportunities to be tactical in response to price dislocations. This includes the ability to invest in absolute return, low beta, alpha-oriented strategies for times when both traditional and real return funds offer meager risk-adjusted returns.


The French built the Maginot Line after the First World War to prepare for another potential trench warfare conflict with Germany. They erected no defenses along the Benelux borders on the incorrect assumption that Germany would only invade along the shared German–French border. Like today’s 401(k) asset allocation, this flawed strategy was backward-looking. We assert that defined contribution investors are bunkered with stocks and bonds preparing for a battle of disinflation, fighting a forgotten war—just as a reflation is about to blitzkrieg their unprepared portfolios. It is time for investors and their advisors to look forward, not backward, in their 401(k) investment planning.

Inflation is the biggest single enemy to long-term investors. A portfolio of real return assets balanced with a stock- and bond-heavy 401(k) fund menu is the better way to build a portfolio for an uncertain future. To do this, one needs to include inflation hedges before inflation strikes and when they are least costly.

Don’t plan for the future by fighting the battle of the past 30 years.



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