Inflation is defined by the rate at which the value of a currency is falling and, consequently, the general level of prices for goods and services is rising. Inflation is a natural occurrence in an economy, but inflation hedging can be used to offset the anticipated drop in a currency's price, thus protecting the decreased purchasing power.
Inflation hedging can also help protect the value of an investment. Although certain investments may seem to provide a decent return, they can be sold at a loss when inflation is factored in.
A disciplined investor can plan for inflation by cultivating asset classes that outperform the market during inflationary climates. Although traditional bonds are the usual go-to for the income-oriented, they aren't the only investment that produces a revenue stream.
- Inflation is a natural occurrence in an economy, and a disciplined investor can plan for it by cultivating asset classes that outperform the market during inflationary climates.
- Shifting funds from bonds to stocks, especially preferred shares, is one strategy.
- Real estate usually performs well in inflationary climates; REITs are the most feasible way to invest.
- Adding global stocks or bonds to your portfolio also hedges your portfolio against domestic inflationary cycles.
- Another option is more exotic debt instruments like TIPS (inflation-adjusted Treasury bonds).
- Buying senior secured bank loans is another way to earn higher yields while protecting yourself from a price drop if rates start to rise.
Here are the top five asset classes to consider when seeking protection from inflation. They range from equities to debt instruments to alternative investments. All are feasible moves for the individual investor to make, though they carry different degrees of risk.
1. Reallocate Money Into Stocks
If inflation returns, it's generally a punch in the jaw for the bond market, but it could be a shot in the arm for the stock market. Consider reallocating 10% of your portfolio from bonds to equities in order to take advantage of this possible trend.
A 60/40 stock/bond portfolio is considered to be a safe, conservative mix of stocks and bonds. An example of a stock/bond portfolio is the Dimensional DFA Global Allocation 60/40 Portfolio (I) (DGSIX).
A 60/40 stock/bond portfolio is an easy investment strategy and will help you hedge against inflation, but keep in mind it will underperform over the long term compared to an all-equity portfolio because of the effects of compounding interest. You may find yourself missing out on returns compared to a portfolio with a higher percentage of stocks.
Buying preferred stocks is another possibility. These liquid issues will pay a higher yield than most types of bonds and may not decline in price as much as bonds when inflation appears.
Utility stocks represent a third alternative, where the price of the stock will rise and fall in a somewhat predictable fashion through the economic cycle and also pay steady dividends.
2. Diversify Internationally
American investors tend to lean towards stocks and bonds in the U.S, but the practice can be costly over the long term, especially during times of inflation. Increasing international exposure can be a good strategy to hedge against inflation.
There are several major economies in the world that do not rise and fall in tandem with the U.S. market indices, such as Italy, Australia, and South Korea. Adding stocks from these or other similar countries can help to hedge your portfolio against domestic economic cycles. Bonds from foreign issuers can provide investors with exposure to fixed income that may not drop in price if inflation appears on the home front.
Exchange-traded funds (ETFs) and mutual funds are two of the easiest options to diversify investments into international markets. These types of funds are a low-cost way to invest, compared to purchasing a portfolio of American Depositary Receipts (ADRs) or foreign stocks. If you hold S&P 500 index funds, you may want to consider adding an international index fund to your portfolio.
The percentage of international equities and bonds in the portfolios of U.S. investors, despite the fact that international markets represent 60% of global public capital markets. This phenomenon is known as "home-country bias."
3. Consider Real Estate
There are many advantages to investing in real estate. This asset class has intrinsic value and provides consistent income through dividends. It often acts as a good inflation hedge since there will always be a demand for homes, regardless of the economic climate, and because as inflation rises, so do property values, and therefore the amount a landlord can charge for rent.
Because real estate is a tangible asset, however, it's illiquid. An alternative to consider is real estate investment trusts (REITs), which are more liquid investments and can be bought and sold easily in the markets. REITs are companies that own and operate portfolios of commercial, residential, and industrial properties. Providing income through rents and leases, they often pay higher yields than bonds. Another key advantage is that their prices probably won’t be as affected when rates start to rise, because their operating costs are going to remain largely unchanged. An example of a REIT with broad exposure to real estate and a low expense ratio is the Vanguard Real Estate ETF (VNQ).
4. Look to TIPS
Treasury inflation-protected securities (TIPS), are a type of U.S. Treasury bond, designed to increase in value in order to keep pace with inflation. Because they’re backed by the U.S. federal government, they’re considered among the safest investments in the world.
The bonds are linked to the Consumer Price Index and their principal amount is reset according to changes in this index. TIPS pay interest twice a year at a fixed rate, which is applied to the adjusted principal. The principal rises when there is inflation and falls when there is deflation. TIPS come in three maturities: five-year, 10-year, and 30-year.
There are however a few risks that come with TIPS. They are sensitive to any change in the current interest rates, so if you sell your investment before maturity, you may lose some money.
5. Buy Bank Loans
Some businesses can thrive during inflation, when prices are rising. Banks, for example, earn more money as interest rates rise and profit off the increased price of loans.
Buying senior secured bank loans is a good way to earn higher yields while protecting yourself from a price drop if rates start to rise. Keep in mind, though, that there may be a substantial time lag until the value of loans increases as the rates rise. An example fund of this type is the Lord Abbett Floating Rate Fund (LFRAX).
Many of these investments are complex instruments, and novice investors may be wise to buy them through a mutual fund or exchange-traded fund (ETF). For example, the Vanguard Global Ex-U.S. Real Estate Index (VNQI) offers broad-based exposure in properties around the world. The iShares TIPS Bond ETF (TIP) tracks the performance of inflation-protected U.S. Treasury bonds. The Lord Abbett Floating Rate Fund (LFRAX) is one good choice for those who seek exposure in lower-grade corporate loans.
What Is Historically the Best Hedge Against Inflation?
The best hedge against inflation, historically, depends on your time frame. Commodities are often cited as a good bet for keeping up with the cost of living—especially gold. However, research by Duke University professor Campbell Harvey and Claude Erb, former commodities and fixed income manager at TCW Group, shows that gold works best as an inflation hedge only over the very long-term—a century or more.
Many analysts and economists feel equities are a better way to protect your portfolio over the long term, particularly against an unexpected flare-up of inflation. Corporate earnings often grow faster when inflation is higher because this indicates people are spending and the economy is growing. While it has its ups and downs, over the past 100 years, the stock market (as represented by the S&P 500) has appreciated an average of 10% annually.
Is Gold a Good Hedge Against Inflation?
One of gold's traditional selling points has been its status as an inflation hedge. As an actual, tangible asset, gold tends to hold its value for the most part—unlike paper currencies like the dollar, which lose purchasing power when inflation is rampant.
With rising inflation, gold typically appreciates. However, gold isn't a perfect inflation hedge. Other factors can drive its prices, which can fluctuate wildly from year to year—which means its inflation-adjusted returns can too. In fact, over the last 1-, 5-, 10-, 15- and 20- year investment horizons, the variation in the nominal and real returns of gold has not been driven by realized inflation.
Is Bitcoin a Strong Hedge Against Inflation?
Theoretically, bitcoin could be a strong inflation hedge. Assets that investors run to in times of rising prices—so-called safe-haven investments like precious metals and real estate—are ones that are scarce or move counter to paper money or financial assets. Bitcoin fits the bill.
The problem is, bitcoin hasn't much of an investment history: Created in 2009, it's only been actively traded for a decade or so, and inflation hasn't been much of a factor for most of its short life.
So no one really knows how inflation will affect bitcoin and its characteristically volatile behavior. Certainly, its performance has been puzzling vis-a-vis inflation of late. Bitcoin doubled from mid-December 2020 to early January 2021, as inflation started to heat up. But then, with no apparent easing of inflationary pressures, between Jan. 8 and Jan. 11, it lost 25% of its value.
In May 2021, inflation talk intensified: As the Federal Reserve signaled a retreat from easy-money pandemic policies and a rise in interest rates, stocks trembled—but bitcoin really tumbled. On May 19, it culminated a month-long slide by closing at $38,390—a 41% decline from its peak of $64,829 in mid-April.
Can Real Estate Hedge Against Inflation?
Real estate is one of the time-honored inflation hedges. It's a tangible asset, and those tend to hold their value when inflation reigns, unlike paper assets. More specifically, as prices rise, so do property values, and so does the amount a landlord can charge for rent, so that the property earns higher rental income over time.
There's also the phenomenon of “depreciating debt”: that is, the cost of the real estate owner’s mortgage payments actually declines. For example, say your mortgage payments add up to a fixed $8,333 per month during the first year of your loan. They will remain the same nominally—$100,000 annually—but may well only be worth $80,000 in the 10th year, if there's been sustained inflation during that period.
All these elements make real estate valuable protection in inflationary times.
The Bottom Line
Inflation happens and is a risk every investor faces. Money tends to lose value over time, and also the level of inflation in an economy changes depending on current events.
There are, however, many ways for investors to hedge against inflation, including some investments and inflation-hedged asset classes designed specifically for that purpose. Keeping these assets on your watch list, and acquiring them when inflation hits, can help your portfolio thrive despite the economic climate.