Dynamic Asset Allocation During Different Inflation Scenarios

Nawrocki, David N.; Evensky, Harold
October 2003
Journal of Financial Planning;Oct2003, Vol. 16 Issue 10, p42
Academic Journal
This article explores the question of whether the asset allocation of a portfolio should be altered depending on the current level of inflation. Since Fama and Schwert (1977) first noted a statistically significant negative correlation between inflation and stock returns, researchers have been scrambling to explain the relationship. The Fishery theory of interest hypothesizes that the nominal return on any asset equals real interest and a real risk premium plus expected inflation. However, Fama and Schwert's finding of a negative relationship between stock returns and inflation contradicts Fisher's theory. The data consist of monthly observations from January 1950 to December 1998. The trading rule is formulated using data from 1951 to 1974. Figure 2 presents the results for the entire period 1951-1998. All switching strategies provide higher reward-to-semivariability ratios and higher reward-to-variability ratios than the appropriate benchmark. The purpose of the switching strategies is to provide short-term liquidity during periods when the stock market is incurring losses due to higher inflation. The switching strategy kicks in during periods of high inflation and was effective in reducing downside risk during volatile market periods such as 1979-1980, 1982, 1987-1988 and 1990-1991.


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