Shrinking dollar bills
When prices rise rapidly and persistently during an inflationary spiral, dollars lose purchasing power and investors can see the value of their portfolios decline. Inflation-hedging strategies try to counter the wealth-eroding effects of inflation by selecting investments that can potentially counter the effects of inflation. Many investing experts recommend strategies involving a mix of equities, short-term fixed-income investments and holdings related to commodities and real estate. Special-purpose vehicles such as Treasury Inflation-Protected Securities (TIPS) also can play an important role. Consider working with a financial advisor to boost your portfolio’s protection from inflation.
Inflation: The Basics
Inflation is the increase in the prices of goods and services across an economy. When prices inflate you need more money to buy the same things. The opposite of inflation is deflation, when prices become lower across a range of goods and services.
Mild inflation is generally seen as beneficial and helping to contribute to economic growth. However, when the inflation rate as measured by the consumer price index (CPI) rises above the 2% rate favored by federal policymakers, it can indicate that inflation is getting out of control. The result can make it harder for consumers and businesses to reach their financial goals and to preserve their existing wealth.
Participants in the securities market are highly sensitive to forecasts of changes in inflation. This means that, as a rule, expectations of future inflation are already factored in to prices for stocks and bonds, including inflation hedges. So these inflation hedges are most useful when unexpected inflation occurs. If the prevailing sentiment has been that inflation is on the way, the prices of securities can be counted on to already reflect that.
Inflation: Common Hedges
Inflation hasn’t been a critical concern since the 1970s, when a sustained period of high inflation devastated the economy, the stock market and consumers’ pocketbooks. However, during that period and the occasional milder inflationary periods since, a number of inflation-hedging tools and approaches have been developed. While there are a number of relatively complex strategies sophisticated investors use to counter the effects of inflation, here are five of the most common:
Equities –Stocks often perform poorly during sustained inflation, but historical returns on equities still outpace inflation by a significant margin. Investing in the stock market, therefore, is a widely used inflation hedge. Shares in companies that have large cash positions and the ability to raise prices without losing customers are seen as especially attractive
Consumer staples – Some businesses tend to do better than others during inflationary spells, and those that sell consumer staples are often popular among inflation-hedgers. These include companies that sell basic foods like milk and bread and necessities such as toilet paper. Pharmaceuticals and utilities are also used as inflation hedges.
Commodities – Businesses tied to natural resources and commodities are frequent refuges during when inflation rises. This category encompasses numerous fields: industrial metals like copper and nickel; crude oil, natural gas and petroleum products; so-called “softs” like corn, timber and soybeans; precious metals, including platinum, palladium and silver. Prominent in the latter sector are gold and gold mining companies.
Real estate – Investing in real estate investments including real estate investment trusts (REITs) are a popular response to inflation. These shares tend to pay sizable dividends and their underlying real estate assets tend to become more valuable during inflationary episodes. Owning actual real estate is also a good inflation hedge.
Short-term bonds – Interest rates generally rise with inflation and that means fixed-income investments, especially longer-term ones, tend to lose value. Short-term fixed-income securities like bonds and other income securities can mitigate this effect because as rates rise new bond issues reflect the current interest environment. Money market fund returns are particularly closely tied to current interest rates.
Treasury Inflation-Protected Securities (TIPS) – The value of these U.S. government fixed-income securities is directly tied to the CPI, increasing as inflation rises. When the bond matures, the investor receives either the amount of the original principal or the amount adjusted for inflation.
None of these strategies is risk-free or guaranteed to beat the rate of inflation or completely counter the effects of rising prices. For instance, TIPS, while highly effective against inflation, pay lower rates than non-inflation adjusted bonds. Natural resources companies, such as gold mining stocks, can be highly volatile.
The Bottom Line
Piggy bank and “inflation”
Inflation – and certainly hyperinflation – can pose a threat to the purchasing power of individuals’ wealth so, when prices appear to be on the rise, people often turn to inflation hedges to protect the value of their portfolios. Many investors use a blended approach to managing the effects of inflation. That is, they may devote a portion of their portfolio to equities, targeting companies in inflation-resistant sectors such as consumer staples, natural resources and precious metals. They also often favor TIPS. What they tend to avoid are asset classes like long-term bonds, cash and cash equivalents.
Tips for Investing
Hedging against inflation calls for a high degree of knowledge about financial instruments as well as awareness of economic trends and an investors’ individual goals and needs. With that in mind, an experienced financial investor can be an invaluable asset when inflation threatens. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
An inflation calculator is one of the most useful planning tools investors have to assess how the purchasing power of their securities may change over time.
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