Many economists and investment experts have been growing worried about deflation. But whereas deflation may be the immediate concern, the more likely scenario over the long term is inflation.

The United States has been running a trade and budget deficit for the past 10 years. And the government debt level has increased significantly after the 2008-2009 financial crisis and subsequent government bailout and fiscal stimulus spending.

These deficits are expected to continue to increase for the foreseeable future. Given these high deficit levels, many economists believe inflation will soon be much higher, even though the current inflation level remains quite low following the recession.

Next year, the first of the 79 million baby boomers will hit 65-retirement age. Many will be relying on the trillions of dollars in assets they have accumulated in IRAs and defined contribution plans. For these investors, traditional equities and fixed income remain their largest holdings. According to the Investment Company Institute, investors in their sixties, on average, invest their portfolios in roughly 50% equities and 50% fixed income.

As retired investors start to withdraw money to meet their expenses, their portfolios must keep up with inflation to help them maintain their living standard. In other words, they need to manage inflation risk.

In this article, we conduct a historical analysis to examine the inflation-adjusted performance of various asset classes, as well as stock- and bond-based retirement portfolios. We'll examine whether a typical portfolio consisting of 50% equities and 50% fixed income can produce inflation-adjusted returns over time.

ASSET CLASSES

We start with four traditional asset classes (and the indexes representing them): U.S. equities (S&P 500), international equities (MSCI EAFE), U.S. bonds (intermediate-term government bonds) and cash (30-day T-bills). We also include two asset classes that are more closely linked with inflation but less commonly used in a typical portfolio-inflation-indexed bonds (TIPS) and commodities (GSCI).

We are using the time period 1970 to 2009 in this analysis. Prior to 1970, the monetary policies as well as exchange regimes (Bretton Woods System) were very different from those today; therefore, the return history prior to 1970 is less relevant. In total, we have 40 years of return history for this analysis.

"In the Black," above, shows the average returns for these asset classes after adjusting for inflation from 1970 to 2009. Overall, inflation averaged 4.5% per year, higher than what we have experienced in the last 10 years. During the 1970s and 1980s, we had much higher inflation, partially caused by the energy crisis.

Despite starting with a higher inflationary environment in the 1970s, every asset class produced positive inflation-adjusted returns over the past 40 years, with U.S. and international stocks, on average, close to 7% per year after inflation, and traditional and inflation-indexed bonds returning more than 3% per year. Commodities also did well, generating an average 8% return per year above inflation.

THREE INFLATION LEVELS

While the averages provide a sense of long-term outcomes, they do not represent the full spectrum of the investor experience. Next, we separate the 40 years of return history into three scenarios based on the level of inflation-low, median and high.

We rank the inflation level each year; the highest 13 years are grouped in the high-inflation scenario, the lowest 13 years are grouped in the low-inflation scenario and the remaining 14 are grouped in the median-inflation scenario. Not surprisingly, performance is quite different across these three scenarios (see "High or Low," at left).

Comparing and contrasting the low- and high-inflation scenarios highlights the difference. In the low- inflation scenario, stocks and bonds produced moderately above-average returns, while commodities returns were much lower than the average over the entire 40-year time period. In fact, commodities lost an average of 3.7% per year after adjusting for inflation.

In the high-inflation scenario, the performances are almost opposite of the low-inflation scenario. Commodities produced much higher returns than the average, while traditional stocks and bonds significantly underperformed their long-term averages.

These differences in return show that traditional stocks and bonds are mostly exposed to high-inflation risk. Commodities, on the other hand, potentially provide strong diversification benefits against high-inflation risk for a traditional stock-and-bond portfolio.

It is also worth noting that Treasury inflation-indexed bond returns were quite similar across the three inflation scenarios. This shows that inflation-indexed bonds are able to produce stable inflation-adjusted returns and that they are less risky than traditional nominal bonds when measured by real purchasing power. The returns also show that inflation-indexed bonds can provide additional diversification benefits compared with traditional stocks and bonds.