Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

DIVERSIFICATION is the cornerstone of any successful investment portfolio. Most investors achieve this through a mixture of stocks and bonds. But history tells us that rising inflation is bad news for both these asset classes.

So as storm clouds gather around the outlook for both inflation and interest rates, here are four investments that could inject some much-needed diversification into your portfolio.

1. Gold: a good idea when there’s stagflation

Gold is often touted as the ultimate diversifier - the place to be when inflation goes up, or the world goes to pot. But, as I’ve pointed out before, anyone who’s held gold will be woefully disappointed with the ‘protection’ the yellow metal has delivered.

It’s worth noting that the gold price falls when interest rates are likely to rise, which means that gold is not the inflation hedge everyone touts it to be. It’s also fair to say that gold has not benefitted from record low interest rates and high inflation this year (so far at least).

But what if stagflation rears its ugly head?

With economic growth disappointing in recent months, and inflation looking more sticky than temporary, stagflation - that toxic combination of rising costs and lower growth - could be back on the cards. And as the 1970s showed us, stagflation wreaks havoc with the economy and financial markets.

Historically, stagflation hits equities hard. The impact on bond returns have been variable, however, both commodities and gold fare well in a stagflationary environment, as the below chart dating all the way back to 1973 shows.

Returns from major assets per cycle phase since 1973

None

Source: Bloomberg, World Gold Council, 2021. Annualised average (stagflation) adjusted returns for major asset classes since Q1 1973, as of Q2 2021.

Past performance is not a reliable indicator of future returns

The reason gold is a trusted port in the storm during stagflation is quite simple: when there’s higher inflation along with market volatility, investors want to preserve their capital, and we know the yellow metal is a great preserver of capital. To illustrate: a Roman toga in ancient times is said to have cost the equivalent of 1 ounce of gold - roughly £1,300 - which is what you’ll expect to pay for a handmade suit today.

It’s also worth noting that record low yields on bonds is likely to well constrain their diversification potential in a market sell-off or ‘risk-off’ event, which could offer gold an opportunity to rake in flows, as investors turn more defensive.

A gold fund on the Select 50 list of our experts’ favourite funds is the Ninety One Global Gold Fund, alternatively the iShares Physical Gold ETC seeks to track the day-to-day movement of the price of gold by holding gold bullion as allocated gold bars.

2. Cash: a little bit, at the right time, can make sense

Holding cash when inflation is rising, might seem counterintuitive (after all rising prices erode the buying power of cash.) There’s also no disputing that cash has been a terrible long-run investment (except in Japan). But over shorter time horizons, the situation is different. Research by Morgan Stanley found that since 1959, the probability of cash outperforming the S&P 500 in any month is 40%, and one in three over any six-month period.

With the perfect storm of rising inflation, Brexit woes, Covid-19, higher energy prices and a lack of clarity on the state of the UK labour market, many fund managers are shunning sterling bonds and choosing to hold that money in cash instead as the so-called “least worst” option.

They’re not alone. Our most recent best-seller fund list, shows a clear flight to cash with private investors too. The Fidelity Cash Fund features as the second most popular ISA investment and the fourth most popular SIPP investment in October.

While cash carries the risk of erosion by inflation, it benefits from higher interest rates and a small allocation, say around 5% to 10%, can act as a handy war chest to buy into any market dips.

3. Agriculture: go hard on soft commodities

Mark Twain is often quoted as saying: “Buy land, they’re not making it anymore.” Today you could paraphrase this to: “Buy food, they can’t make another planet.”

You don’t need to be a climate change activist, or a meteorologist, to have noticed the volatility in the seasons. Severe droughts, floods and deforestation all have an impact on agriculture and introducing some soft commodities such as wheat and corn as diversifiers into your portfolio can make sense.

The complexity of commodity futures prices can make this challenging, but you could do this via an exchange-traded fund or via agriculture equities. Companies providing agricultural products and services such as fertilisers, pesticides, seeds, equipment, and livestock are ways to tap into this theme. Companies listed on the London Stock Exchange include the likes of Anglo-Eastern Plantations, M.P Evans Group and Camellia PLC.

4. Cryptocurrencies: a bit of Bitcoin, or something more sustainable?

A question that’s increasingly asked is whether Bitcoin is the ‘new gold’? This is unsurprising given the growing band of investors suffering from the so-called 60/40 blues.

This mainstay of investment strategy - a 60/40 mix of equities and bonds - may have provided investors with solid returns and lower levels of volatility for decades, but times are changing. With the ‘uncorrelated’ relationship between equities and bonds breaking down and bond yields in the doldrums, many investors are starting to get a bit more creative with the 40% bucket.

Some argue that alongside gold and commodities, a bit of bitcoin in the traditional bucket reserved for bonds could make sense. But you’ll need a strong stomach to deal with the inevitable volatility that comes with crypto - and as Warren Buffett rightly puts it “invest in what you can understand.” Getting your head around cryptocurrencies and how they work, is hard at the best of times.

What’s less hard to grasp, however, is the premise of sustainability as a long-term investment theme - the argument that a company which rates highly on environmental, social and governance (ESG) factors, is a proxy for just being a good company, full stop.

Bitcoin is an environmental disaster as ‘mining’ the crypto requires massive amounts of dirty coal-powered electricity generation. But companies that are socially responsible, diligent about corporate governance and environmentally friendly tend to be the sort of high quality, well-managed companies that most of us want to invest in, and as such are likely to be around for a long time. That’s why I will be filling up my 40% bucket with a few more ESG-focused funds tapping into the latter.

Find out how some leading fund managers invest sustainably in our latest video series.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.

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