Inflation-Hedging, Asset Allocation and the Investment Horizon

Abstract

Focusing on the role of the investment horizon, we analyze the inflation-hedging abilities of stocks, bonds, cash and direct commercial real estate investments. Based on vector autoregressions for the UK market we find that the inflation-hedging abilities of all assets improve with the investment horizon. For long horizons, real estate seems to hedge unexpected inflation as well as cash. This has implications for the difference between the return volatility of real returns versus the return volatility of nominal returns, and ultimately for portfolio choice. Portfolio optimizations based on real returns yield higher allocations to cash and real estate than optimizations based on nominal returns. Bonds tend to be less attractive for an investor taking into account inflation. Switching from nominal to real returns, the allocation to stocks is decreasing at medium investment horizon, but increasing at long horizons.