Detailed Methodology – Allocatewise

Important Information

allocatewise.com does not provide investment advice and you should not be engaging in any investment activity without full understanding or a financial advisor. The below is an example of what an inflation-hedged portfolio may look like. It does not represent a recommendation or endorsement of any product. When investing and also in any of these example portfolios the invested capital is at risk. allocatewise is not responsible for how you use this information. allocatewise is not regulated by the Financial Conduct Authority (FCA) or any other supervisory authority.

Challenge and Solution: Inflation as the Benchmark

Saving money to live from later in life ("retirement") is different from general investing. In general investing the benchmark is the risk-free^† rate paid by governments on their debt. When saving for retirement, the benchmark is the increase in the future cost of living. For simplicity this can be assumed to be inflation - usually expressed as the Consumper Price Index (or CPI). Of course, it is debatable if one's personal consumption costs increase with inflation. But without better alternatives for measuring inflation, using CPI or RPI (in the UK) is better than nothing at all. In addition, nobody knows what their future cost of living will be. The best we can do is to consider current prices for things and extrapolate with inflation.

Looking at retirement savings with consideration to inflation does not only tend to increase the return that is required to exceed the benchmark. It changes the whole equation!

What matters is the performance against the goal of maintaining a good standard of living, as measured by the portfolio's performance against the CPI.

Illustration of the reduction in purchasing power. Since 2005 purchasing power of a Dollar fell by 40% to 60% of it's original value.

Annualised Monthly returns and volatility for different asset types, along with their real returns and correlation of both Nominal and Real Return with US CPI.

Using inflation as a benchmark for retirement savings

In practice, it means that all returns of assets will be measured against inflation.

The table displays the return of these broad ETFs adjusted by the US CPI All Urban Consumer price index. Historical returns are not an indication of the future, but the table demonstrates the potential issue when looking at long-term growth rates of portfolios. Without considering the increase in the cost of living, they are not very informative. Furthermore, apart from commodities, no assets exhibit positive correlation with inflation.

Assets moving with inflation

Some assets are traditionally seen as providing some security against inflation (for example real estate investments). While they share similar trends with inflation, the direct correlation of real estate and inflation is historically relatively small. The same is true for commodities. Assets which tend to correlate with inflation have historically exhibited poor returns (for example, cash or commodities).

Correlation Matrix of different asset classes vs CPI, for Monthly, Yearly and 5-yearly data

Starting with the Real Yield

Performance of inflation-linked bonds is historically not closely correlated with inflation, nor have they shown significant outperformance against inflation. But they provide a very important function: They define what yield above inflation can be achieved at any given point, by taking only marginal risks. Specifically the central government's default and a small reinvestment risk.

Their yield-to-maturity (YTM) above inflation provides a benchmark against all other investment opportunities can be measured. The "real yield".
The UK has continously issued inflation linked bonds with varying maturity. Using the real yield on these linkers a continous real yield curve can be built. In the EUR zone, Germany and France have issued "linkers". For investments in USD a well establisehd US TIPS market provides the real yield curve.

Mapping the real yield of the inflation linked bonds to their maturity dates creates the real yield curve.

Real yield curve: real yields on index-linked gilts by maturity over the next 50 years

Inflation linked bond payout strucutre

Establishing a baseline

Historically, the real yield available in the market has varied considerably and often has been negative. The current real yield curve provides the inflation-relative benchmark rate in the portfolio construction.

For example, an investor who needs to receive 1,000 GBP in 2040 uplifted by inflation can buy the index-linked gilt maturing in that year. Gilts are issued by the UK government, which has never defaulted on a gilt, though that is not a guarantee of future performance. The market price of an index-linked gilt can go up or down, but unless the UK Government defaults it will deliver the promised inflation-linked cashflow at maturity. That redemption amount in 2040 incorporates compensation for the inflation experienced in the meantime.

It is important to note that this is only true if the index-linked gilt is held to maturity.

The efficient frontier graph

Assessing investments vs. real yield

In efficient markets risk is on average compensated by increased returns. How much risk to take, and in which asset classes, is an individual decision. But the question is how much and in which assets an investor should invest.

Since the introduction of portfolio theory in the 1960s, it is a well known concept to create an "efficient frontier" - meaning the combination of assets which is expected to have the least variation in returns given a specific return. The allocatewise.com App uses this concept based on historical correlation and returns - or user-based inputs - to calculate an efficient frontier relative to inflation. The software solves for the minimum variance portfolio given a return and the selection of asset classes, as well as the historically observed features of asset classes.

Mixture of 'risk-free' real yield and risky portfolio

The actual allocation in a retirement portfolio depends on each individual's risk appetite and 'utility function' i.e. how much additional return someone needs to receive in order to take on additional risk.

Each portfolio is a combination of "risk-free"^† and risky portfolio i.e. a inflation-linked portfolio and a portfolio based on the asset selection and covariance inputs. How much each individual investor invests into the risky and the risk-free portfolio is guided by their preference and risk tolerance. Allocatewise shows how the modelled statistics change across combinations; it does not indicate which combination is attractive for you. There is some academic guidance around it and you are invited to research relevant concepts. For example the Merton Share or the Kelly Criterion .

You may also use the risk slider in our app to get a feel for the sensitivity of allocations to risk appetite.

† "Risk-free" is used here in the inflation-relative sense, and it holds only for a gilt held to maturity. Gilts are issued by the UK government, which has never defaulted on a gilt, though that is not a guarantee of future performance. The market price of an index-linked gilt can go up or down, but unless the UK Government defaults it will deliver the promised inflation-linked cashflow at maturity. A gilt sold before maturity may return less than was paid for it, so the term does not mean the value cannot fall.

Visualization of allocatewise portfolio construction methods using risk-free and risky portfolio mixture