How to Build an Inflation-Proof Portfolio (And 3 Mistakes to Avoid)

0:00The best portfolio for fighting inflation is not the one that reacts most cleverly to inflation signals. It's the one that compounds over the longest period with the fewest interruptions to its own growth.

0:36to where you need to be. Quick note before we get into it, June's pre-order incentive for my book, Real Wealth, is the most personal thing I've ever agreed to share. Pre-order in June and submit your receipt at tylergardner.com and you'll get an exclusive three-episode audio series that will never appear on this feed. Three pivotal moments in my own financial life, the humbling one, the embarrassing one, and the one that made me rethink everything. Three episodes, three moments, tylergardner.com, pre-order, submit your receipt, get the episodes delivered digitally in early July, and receive every additional monthly incentive between now and the book's release on December 1st.

1:20And now, on to today's episode. I have a simple rule about the content of this show. If a word appears on the news more than three times in a single segment, I try to wait at least six months before touching it. I've been waiting. The clock ran out, so today we're going to address it full-on. Inflation. Inflation is, at its core, a very simple concept dressed up in very complicated language so that economists have something to do at conferences and pundits have something to worry you about on Monday morning news cycles. Here is what it actually is. The dollar you have today buys less stuff on average tomorrow.

2:05Not usually dramatically less. We're not talking Weimar Republic or wheelbarrows full of cash. We're talking about the slow, steady, unspectacular erosion of purchasing power that compounds over decades until you look up and realize that the house your parents bought for$40 ,000 in 1978 is now worth$600 ,000, and a cup of coffee at the airport now costs$8.50, and somehow both of these facts are true simultaneously. Over the last century, U.S. inflation has averaged roughly 3 % per year. That sounds manageable, and for the most part it is, until we run some numbers that I want you to think about today.

2:49At 3 % annual inflation, your purchasing power, just meaning what you can get in the future for that same$1 bill is cut in half in about 24 years. So if you retire at 65 and live to be 90, which a meaningful percentage of you will, your dollar in retirement year one is worth 50 cents by the end of your retirement. And I feel like that's a pretty useful starting point for you heading into this next chapter of your life, because your portfolio has to outrun that every year for decades, even while you're sleeping, preferably in a lazy boy chair while watching reruns of The Price is Right. That is what today's episode is about.

3:35We're going to build three portfolios, going from simple to slightly more complex, that are specifically designed to tackle inflation. And then we're going to cover three mistakes that investors make that work directly against them in an inflationary environment. Mistakes that are extremely common, but extremely easy to avoid. And before we get into it, a familiar ask if you have found this show even remotely useful. If it has saved you money, clarified something confusing, made you feel slightly less like you're wandering through a financial hall of mirrors, would you consider leaving a review on Apple Podcasts or Spotify?

4:16Takes about 45 seconds, costs you nothing, and it is genuinely the highest leverage thing you can do to help this show reach people who need it. Thank you in advance, and now let's figure out together how to build the perfect portfolio to protect you against the damaging effects of inflation. Part 1. The Foundation. Why most portfolios fail at inflation. Before we build anything, I want to explain why the standard balanced portfolio that the financial industry has been selling for decades is actually a fairly mediocre inflation-fighting tool. The classic 60-40, 60 % stocks, 40 % bonds, has a well-documented problem in inflationary environments.

5:06Bonds, particularly long-duration bonds, get absolutely punished when inflation rises. And here's why. In one sentence, inflation erodes the value of the fixed payments a bond makes. And when inflation expectations rise, interest rates tend to rise to slow down the borrowing of additional capital. And when interest rates rise, existing bond prices fall because who the heck wants to pay a thousand bucks for my bond earning 3 % if they can go pay a thousand bucks for a bond earning 4%. We saw this happen in 2022. The safe 40 % of millions of balanced portfolios dropped 15 to 20%. People who thought they were protected discovered that they were, in a very specific and uncomfortable way?

6:03Not. Cash is even worse. Cash is just slow motion inflation surrender. You're not losing money visibly. You're just losing purchasing power every single day while your savings account pays you 0.5 % and inflation runs at 4%. You are falling behind in a race you didn't know you'd entered. So, what actually beats inflation? Three things historically, all with very strong academic support. First, equities. Stocks in good companies represent ownership of real assets. Factories, intellectual property, brand value, productive capacity. Over time, companies can pass rising costs onto consumers, which means their revenues and profits tend to grow with inflation.

6:58The stock market over long periods has returned roughly 7 % annually in real terms, meaning after inflation. Nothing else comes close on that metric over 30-plus year horizons. Two, real assets. These are physical things, real estate, infrastructure, commodities, whose prices tend to rise with inflation because they are literally inflation. They are the things whose prices are being measured. And three, inflation-linked bonds, specifically TIPS, Treasury Inflation Protected Securities, which are U.S. government bonds whose principle is explicitly adjusted upward with the consumer price index. They are the one fixed income instrument that actually does what people think bonds do, protect you when inflation rises.

7:59Today's three portfolios are built around these three tools. So let's build them and see what they look like in practice. Portfolio number one, and I'm going to call this the Burton Malkiel special. 90 % stocks, 10 % tips. Let me start by telling you that this is not my idea. This is Burton Malkiel's idea. For those who don't know the name, Burton Malkiel is the Princeton economist who wrote A Random Walk Down Wall Street, which has sold over 2 million copies and is arguably the most important personal finance book you could ever read. And yes, this is the same Burton Malkiel who I had the wonderful opportunity to interview a few months back, had the most intriguing conversation of my life, and couldn't pass it along to you because I apparently forgot to press record on Zoom.

8:52Not that I'm still devastated by that truth. Anyway, he's been making the case for simple, low-cost index investing for 50 years, which means he was right about everything long before being right about it became popular. And Malkiel shared with me that his own preferred portfolio is something very close to this, overwhelmingly stocks with a meaningful allocation to tips as the risk-off component, not bonds, tips. And when Burton Malkiel tells you something about portfolio construction, the correct response is to listen and learn. On the stock side, for the 90%, a US total stock market index fund, broad, cheap, indexed, and here's the part most people underestimate, already more global than it sounds.

9:47The companies inside VTI, or FSKAX, to total US stock market funds generate roughly 40 % of their revenues from outside the United States. Apple sells iPhones in 175 countries. Microsoft's cloud infrastructure runs businesses on six continents. Johnson & Johnson operates in virtually every nation that has hospitals, which is in fact most of them. When you own the US total market, you're not making a domestic bet. You are owning the most competitively dominant multinational companies on the planet who happen to be headquartered here. That said, and as this episode is focused on inflation hedges for predominantly U.S.

10:34investors, international developed markets are a legitimate inflation hedge for one specific reason. If inflation is running hot in the U.S. and other economies are doing slightly better, international equities can outperform. That's a real scenario, it's happened historically, and it's worth acknowledging. But my honest read, international stocks have underperformed U.S. equities for the better part of two decades, and the structural advantages of U.S. markets, deeper capital markets, stronger shareholder protections, more dynamic innovation ecosystems don't just disappear overnight. If you want a small international sleeve, something like 10-15 % in VXUS is a reasonable hedge.

11:24If you'd rather keep it simple and US focused, the multinationals already inside your total market fund are doing more international work than you might ever realize. So for this portfolio, we're going US total market VTI or F-S-K-A-X. And the remaining 10 % to tips. This episode is brought to you by Element. Heading into the summer, Element just dropped what is essentially their version of an Arnold Palmer, lemonade iced tea. And I currently have a full picture of it sitting in my fridge. A little caffeine alongside the salt and electrolytes is exactly what I want after a long walk through the woods with the bloodhounds or in the late afternoon when I'd otherwise be reaching for a second cup of coffee that I don't actually need.

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13:02This episode is brought to you by Whisperflow. In eighth grade, I won Mavis Beacon Teaches Typing. I realized that sentence requires some unpacking. It was a competition, at least in my mind, even though the software had no awareness of me or my ambitions. I clocked 120 words per minute and have been mentioning it with a type of pride ever since, the way some people never stopped talking about the marathon they ran in 2011. Then I started using WhisperFlow, and it turns out I'm not that fast. I'm just slow in a way I had never really compared to anything. You can talk roughly three times faster than you can type, regardless of how emotionally attached you are to your 8th grade typing score.

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14:30Head to whisperflow.ai slash Tyler. That's W-I-S-P-R flow.ai slash Tyler. Now, what the heck are tips? Because no, we're not talking about the thing you're supposed to now give every random flipped iPad in America when you're checking out. Tips stand for treasury, inflation-protected securities. They are bonds issued by the U.S. government with one very special feature that regular bonds do not have. The principle adjusts with inflation. Here's what that looks like in plain English. You buy a TIPS bond with$1 ,000 face value. Inflation runs at 4 % this year. Your principle will be adjusted to$1 ,040.

15:21Your interest payment, which is a fixed percentage, is now calculated on the new higher principle. So when inflation rises, your TIPS rises with it. When you hold TIPS to maturity, you get back the inflation-adjusted principle, not the original amount. This is the one fixed income instrument that is structurally aligned with inflation rather than structurally harmed by it. The drawback, TIPS yields, what's called the real yield, meaning the yield above and beyond inflation, can be low or even negative in certain environments. So to be super clear, you're not buying TIPS for explosive returns. You're buying them for purchasing power preservation with the backing of the US government.

16:13That is a specific job, and they do that job very well. Here's how to buy them. You have two options. Option one, go to treasurydirect.gov and buy individual tips directly from the U.S. government. The benefits would be no brokerage fees, no expense ratio. You own them directly. This is the pure version. Option two, you buy a tips ETF or mutual fund through your brokerage account. VTIP, Vanguard Short-Term Inflation Protected Securities ETF, or SCHP, Schwab's US TIPS ETF, give you diversified TIPS exposure with tiny expense ratios. We're talking 0.04 to 0.05%. The trade-off versus direct ownership is that a fund doesn't have a fixed maturity date, so the principal adjustment works a little differently.

17:10For most people, the fund is simpler and usually perfectly adequate. Now, the real return expectations for this portfolio. In real terms, that means after inflation, this portfolio has historically returned something in the range of 6 to 7.5 % annually over long periods. The stock component drives that. The tips component preserves the purchasing power of the risk off-sleeve rather than eroding it. And the key here, over a 25-year retirement, the compounding difference between a TIPS allocation and a cash allocation is significant. Strengths of this portfolio. It's brutally simple as it contains two funds.

18:00Maximum long-term inflation fighting power from the equity side. TIPS provide the one form of fixed income that is structurally inflation protected. And it's got Malkiel's endorsement, which I consider non-trivial. Weaknesses. 90 % stocks means real volatility. In 2008, this portfolio might have dropped roughly 40%. In 2020, it dropped 30 % in about five weeks. If that level of drawdown causes you to sell, the theoretical return advantage disappears entirely. And another weakness, tips tend to underperform regular bonds in low inflation environments. So if inflation stays subdued, you're paying a small premium for protection that you didn't end up needing.

18:49This is just a type of portfolio insurance, and insurance sometimes doesn't pay out. And that's fine. The financial industry's response to a portfolio this simple is usually something along these lines. But what about sector rotation? What about your risk tolerance questionnaire? What about our proprietary asset allocation model? And the answer is that their proprietary asset allocation model has a pretty big expense ratio attached to it. And that expense ratio is exactly what we're trying to keep as low as possible. A two fund portfolio does not generate advisory fees. That's not a coincidence.

19:27That is at the core of everything we've always been trying to do together. Portfolio number two, add one real estate sleeve. Allocation strategy, 75 % stocks, 10 % tips, 15 % real estate. Real estate is one of the oldest and most intuitive inflation hedges in human history. When prices rise, property values also tend to rise. When rents rise, rental income rises. Real estate is, almost by definition, a real asset. And real assets tend to keep pace with the inflation that is, after all, largely measured by the prices of real things. In this portfolio, we'd be adding a 15 % real estate allocation to the core Malkiel framework.

20:23And here's how to think about what you might add depending on your situation. Option A, you could add REITs, real estate investment trusts. If you don't own investment property and don't want to deal with tenants, toilets, or the kind of 2am phone calls that age a person, REITs are your vehicle. A REIT is a company that owns income-producing real estate, apartment complexes, office buildings, shopping centers, warehouses, data centers, hospitals, and is legally required to distribute at least 90 % of its taxable income to shareholders as dividends. This makes them natural income generators and natural inflation participants because the underlying rents and property values tend to rise with prices.

21:18VNQ, Vanguard's real estate ETF, is the simple, low-cost choice. It holds over 160 REITs across property types and has an expense ratio of 0.12%. SCHH, that's Schwab's U.S. REIT ETF, is similarly cheap and diversified. Now, here's the nuance worth knowing. REITs are also interest rate sensitive. When rates rise rapidly, as they did in 2022, REIT prices tend to fall, even as the underlying inflation they're supposed to hedge is rising. This is a short-term mechanical tension, not a long-term structural flaw. Over 10-plus year periods, REITs have historically kept pace with and often exceeded inflation.

22:09But in the short run, they can feel like they're doing the opposite of what you bought them for. Patience, as always, is required. Option B, direct real estate ownership. If you already own a rental property or are open to the idea, this is worth a brief mention because it is one of the most powerful inflation hedges available to an individual investor, and it comes with leverage built in. Here's the quick inflation math on direct real estate ownership. Let's say you buy a$400 ,000 property with$80 ,000 down, that would be 20 % to avoid PMI. And that property appreciates 4 % in an inflationary year.

22:53You've made$16 ,000 on an$80 ,000 investment. That's a 20 % return on your actual cash, not the property value. That's leverage. Inflation on the full asset value, return measured against your equity. Additionally, your mortgage, if you have a fixed rate one, is being repaid in increasingly cheaper dollars as inflation runs. The bank lent you dollars worth X in 2020. You're repaying them in dollars worth 0.85x in 2024. Inflation literally erodes your debt burden. I want to make that one personal for a minute. This is precisely why I do not pay down my mortgage. I have a 30-year fixed rate at 3.25%.

23:47Yes, we got in while the getting was good, but that's not the best part. The best part is that regardless of your rate, for the next 25 years, every time I look at that fixed monthly payment, I'll know in my heart of hearts that it is actually not fixed. It's getting cheaper and cheaper and cheaper for me to pay the bank as inflation continues to rise at its historical averages. Now, the drawbacks of real estate ownership are pretty real. Concentration risk, liquidity risk, management burden, and the fact that a bad tenant can ruin your year in ways that a bad REIT ETF simply cannot. Direct-to-real estate is also not passive, despite what those Finfluencer ding-dongs are telling you on TikTok.

24:35But for people who have it and manage it well, it is one of the better inflation hedging tools available to a non-institutional investor. This episode is brought to you by Copilot Money. I have a group chat with four of my closest friends from my finance days. Between us, decades of managing other people's money, multiple licenses, and an embarrassing amount of opinions about actively managed funds. These are not people who download budgeting apps. These are people who tend to mock budgeting apps. And yet, every single one of them uses co-pilot money. The group text now contains, between bond market commentary and bills game updates, sincere love letters to a finance app.

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27:33Join the thousands of parents who trust Fabric to help protect their family. Apply today in just minutes at meetfabric.com slash Tyler, meetfabric.com slash Tyler, and use my link so they know I sent you. M-E-E-T fabric.com slash Tyler. Policies issued by Western Southern Life Assurance Company, not available in certain states, prices subject to underwriting and health questions. Here are the real return expectations for this portfolio. Now, this will be modestly lower than portfolio one in pure expected return because you've taken 15 % out of stocks and put it in real estate, which has historically returned somewhat less than broad equities over very long periods.

28:20But you've added an asset class with a direct inflation linkage and lower correlation to stocks, which can make the diversification effect even better. Strengths of this portfolio, real estate adds direct inflation participation, REITs provide income that often grows with inflation, lower correlation to stocks than bonds, so you have genuine diversification, direct ownership adds leverage and debt erosion benefits. Weaknesses, REITs can fall in rising rate environments despite rising inflation. Direct real estate is illiquid and management intensive. And three asset classes, though still simple, does require slightly more attention than portfolio one.

29:10Portfolio three, add infrastructure. 65 % stocks, 10 % tips, 15 % real estate, 10 % infrastructure. This is the most sophisticated of the three portfolios, and I want to make the case for the asset class we're adding, infrastructure, because it is underused in individual investor portfolios and has a stronger inflation hedging argument than almost anything else you could put in that final 10%. Now, what is infrastructure exactly? Infrastructure funds own the physical backbone of modern economies. Toll roads, airports, pipelines, water utilities, electricity transmission networks, cell towers, ports.

30:02These are not exciting businesses. They will never be the subject of a breathless CNBC segment. They are, however, businesses with one very specific and very valuable characteristic. Their revenues are frequently contractually linked to inflation. A toll road operator doesn't set its own prices based on supply and demand. In many cases, the toll is contractually allowed to increase by the rate of inflation or by a fixed percentage per year as part of the original concession agreement with the government. This means the revenue literally adjusts with prices, not eventually, not approximately, but explicitly by contract.

30:45Same for many water utilities, regulated pipelines, and electricity networks. This is a categorically different kind of inflation protection than equities provide. Stocks beat inflation over time because productive companies adapt. Infrastructure beats inflation in specific periods because the contracts say it will. It's the difference between most likely keeps up and legally required to keep up. And here's how you can own it. IFRA is iShares US infrastructure ETF. It focuses on US infrastructure companies like utilities, transportation, construction, has an expense ratio around 0.3%, which is higher than I like, but it's a necessary evil if you want this type of ownership.

31:35TOLL is a more targeted toll road and transportation infrastructure play if you want to emphasize the contractual inflation linkage specifically. For a global infrastructure allocation, which gives you exposure to the excellent toll road and utility concession businesses in Europe, Australia, and Canada, PAVE or IGF could work well. And finally, for utilities, VPU, Vanguard Utilities ETF, are a simpler, more accessible proxy. Utilities are regulated monopolies whose rates are set by government commissions, and those commissions generally allow rate increases when costs rise with inflation. Not a perfect inflation hedge, but a historically reliable one with meaningful dividend income.