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Inflation is every investor’s boogeyman. It is a silent killer that eats up portfolio returns without leaving a trail as it erodes the purchasing power of its gains. It can turn once-profitable assets into money-losing machines.
If you have been worrying about what higher prices in the economy can do to your investments, we are writing this article to provide detailed information about how inflation can affect a portfolio and what investors can do to hedge against it.
What Is Inflation?
Inflation is a process that involves the progressive and sustained rise in the price of multiple goods and services available within a certain economic system. In the United States, inflation is typically measured by the Consumer Price Index (CPI), a statistic compiled by the U.S. Bureau of Labor Statistics since 1913.
The CPI is a measure that tracks the evolution of prices for multiple items including energy, food, vehicles, shelter, and medical care, among others, by assigning them a weight that is proportional to their relevance in the average household budget.
Although the U.S. Bureau of Labor Statistics has been reporting the CPI on a monthly basis since 1913, the index has a baseline that can be traced back to a certain date. This is the date on which prices started to be measured and, in the case of the CPI, the base (set at a 100) goes back to 1982 – 1984 (inclusive).
The percentage variation in the index between a given period and the immediately preceding period is typically interpreted as the inflation rate. Inflation can be measured on a monthly, quarterly, and annual basis.
As prices rise across the economy, the real value of the US dollar — also known as its purchasing power — deteriorates. Therefore, high inflation is not good for investors as it erodes the purchasing power of both the gains and the principal exposed to different assets.
During times of controlled inflation — typically 2% or less — the impact of inflation goes relatively unnoticed. However, if inflation surpasses that target, some assets may start to yield negative real returns. These real returns are measured by deducting the inflation rate for a certain period from the asset’s realized return.
✎ Pro Tip
There are many variables in an economy that contribute to inflation, however in a nutshell, prices tend to go up when the demand for goods and services is more than the economy supplies. On the opposite, prices tend to go down when the economy supplies more goods and services than people want or need.
How Does Hedging Against Inflation Work?
The logic behind hedging against inflation is that some asset classes and individual instruments can outperform inflation or at least produce break-even real returns. For investors, tactical asset allocation during times of elevated inflationary pressures is crucial to protect one’s portfolio from the ongoing erosion of the purchasing power of the US dollar.
Hedging may involve selling some instruments that will surely underperform during times of high inflation and buying others that will probably outweigh the negative impact of steadily decreasing purchasing power.
That said, hedging could also mean assigning a higher weight to assets that will perform better during inflationary cycles.
Here’s an example of how hedging looks in practice. Let’s say that Henry has a portfolio of Treasury bonds yielding 2.5% a year and some high-quality stocks.
If inflation is expected to increase 5% per year, Henry’s bond holdings will yield a negative return of 2.5% per year. This means that Henry will lose money by holding those instruments due to the impact of a diminished purchasing power of his dollars.
As a result, Henry should either get rid of those bonds or reduce his exposure to them while increasing his exposure to assets that have historically outperformed inflation — i.e., stocks.
Inflation Proof Investments Worth Considering
Now that we have touched on what inflation is and how it can affect an investment portfolio, let’s take a look at assets that typically produce neutral or positive real returns during inflationary cycles.
Stocks are pieces of a business. A business charges its customers a certain price for the goods and services it produces/renders and this gives the company the ability to pass on inflation to consumers via higher prices.
To some extent, stocks typically perform well during times of high inflation because of this phenomenon. However, investors should be aware that not all businesses are created equal. Some companies may find it hard to increase prices without suffering a significant decline in business volumes.
These companies produce goods or services that are considered “elastic”, which means that sell volumes drop if the price is increased. In most cases, the best stocks for times of elevated inflation are those that have high pricing power.
Think of Coca-Cola, for example. If the company increases the price of a bottle from $1 to $1.05 it is highly unlikely that consumers will start drinking less of one of the most beloved beverages of all time just to save five cents. Companies like Coca-Cola can fully pass on inflation to consumers. They are typically referred to as “defensive” stocks.
There has been a fair deal of debate about gold’s ability to protect investors from the impact of inflation. This precious metal gains value just because people and governments have seen it as a good store of value for centuries.
Since this is still the view among millions of people, gold may continue to act as a hedge during times of sustained price increases. However, a recent study from the World Gold Council (WGC) showed that gold alone has not acted as the best asset to outperform inflation in the past.
Instead, assigning gold with a certain percentage of the total portfolio is the best way to use its hedging capabilities to protect one’s holdings against the loss of purchasing power.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) were launched in 1997 by the US Treasury Department as a tool through which investors can protect their net worth from losing purchasing power during times of elevated inflation.
The mechanics of these bonds is simple. The principal of the bond is adjusted periodically based on the fluctuation of the CPI during the period.
These bonds also pay a relatively small annual interest rate that is paid every six months or annually and it is calculated based on the adjusted principal of the bond — that is, their nominal value plus all accumulated inflation-related adjustments.
Once the bond expires, the investor receives the principal invested along with all adjustments made to the initial amount.
✎ Pro Tip
Investors can purchase TIPS directly from the TreasuryDirect website, through a broker to buy a certain fund or through an ETF.
Floating-rate bonds are fixed-income instruments whose interest rate is adjusted based on the fluctuation of a benchmark rate. If the benchmark rate (i.e., federal funds rate or the LIBOR rate) increases or decreases, the interest rate paid on the bond will be modified accordingly.
In some cases, floating-rate bonds could be a great alternative for hedging against inflation. However, their ability to do so will depend largely on how the benchmark rate reacts to inflation once it appears.
If this rate remains unadjusted despite the fluctuation in prices within the economy, then the instrument’s hedging capability will be limited.
Real Estate & Real Estate Investment Trusts (REITs)
Real estate assets, similar to stocks, are typically considered a good way to hedge against inflation. However, this depends on the factors that are driving inflation higher. For example, a sudden increase in the monetary supply of a country can result in a spike in asset prices across the board as too much money is chasing the same limited number of assets.
On the other hand, if inflationary pressures come from external factors such as an oil shock, unexpected food shortages, or other similar situations, chances are that the price of properties may not be necessarily favored to the extent that they can protect an investment portfolio from succumbing to inflation.
In summary, real estate prices “tend” to keep up with inflation, but not in all circumstances. Investors can consider adding exposure to real estate (including REITs) in their portfolios.
Commodities are the door to the business world and the everyday needs of mankind. These items are considered either raw materials for companies to produce goods or are essential to people as is the case of food, gasoline, and natural gas.
In most cases, periods of elevated inflation are marked by higher commodity prices, especially if the cause of inflation is the implementation of overly accommodative monetary policies or a supply-side shock.
With this in mind, investors can hedge their portfolios by acquiring a select basket of commodities. This can be done by purchasing an exchange-traded fund (ETF), buying futures contracts, or acquiring and storing these items physically.
Alternative investments are an ample group of heterogeneous assets whose performance and volatility can be unique. This makes it difficult to categorize them all as plausible inflation hedges.
This group includes venture capital, private equity, fine art, fine wine, cryptocurrencies, and even structured debt products.
There is some truth that most of these “alts” may perform well during inflationary periods. They are considered real assets that will probably receive a sizable amount of inflows at times when investors are looking to protect their net worth.
However, investors should evaluate each option separately to see the asset has done well historically during previous inflationary bouts.
One alternative that seems to stand out at the moment are digital assets like cryptocurrencies, i.e., Bitcoin.
Bitcoin is considered the digital version of gold. This means that it can be a store of value but with added advantages such as lower storage and transaction costs. Meanwhile, Bitcoin is also divisible, scarce, and unique. All things considered, Bitcoin reunites all the characteristics of a feasible store of value in an increasingly digital world as long as its network proves to be as secure as it appears to be.
It is important to note that the price of Bitcoin has surged from $0.01 to nearly $60,000 per coin in 12 years, resulting in a compounded annual growth rate (CAGR) of 267.15%. It has an impressive track record.
✎ Pro Tip
Keeping inflation-hedged asset classes in your portfolio is a good way to diversify your investments and reduce risk.
Investments That Don’t Perform Well During Inflation
We have named some assets that may outperform or at least break even in terms of their real yield. However, some assets will suffer during inflationary cycles.
Long-Dated Fixed-Rate Bonds
Fixed-rate bonds will be the first to take a hit during times of inflation as the holder will immediately see the price of their fixed-income instrument decline to compensate for the now-higher inflation expectations while all interest payments will remain unchanged – meaning that the real rate paid will decline or even turn negative if inflation runs hot.
Long-Dated Fixed-Rate CDs
Certificates of deposit (CDs) will also underperform during times of high inflation as the interest rate will either turn negative or diminish significantly in real terms. The fact that funds are locked, which is the case with most CDs, makes it even more painful for the investor as the funds will remain exposed to inflation until the lock-up period expires.
FAQ About Hedging Against Inflation
The following are some of the most frequently asked questions we get on the topic of how to hedge against inflation.
Is Bitcoin a Good Hedge Against Inflation?
Bitcoin is a digital asset that has some of the attributes that can deem it a good store of value. First, it is scarce since only 21 million BTC tokens will ever exist. Second, it can be easily counted and it is easily divisible (one Bitcoin unit can be divided into 100 million satoshis). Finally, the Bitcoin network — the one powered by the BTC token — is considered durable. This means that it won’t be suddenly destroyed or tampered with.
Overall, Bitcoin meets all of the criteria to be considered a suitable store of value. Therefore, it can be compared to gold.
Is Gold a Good Hedge Against Inflation?
According to data from the World Gold Council (WGC), there is no linear relationship between the performance of gold and the Consumer Price Index (CPI). This means that gold alone is not a good hedge against increasingly higher prices within the economy.
That said, there is a case to be made about how gold can contribute positively to the performance of a well-diversified and inflation-protected portfolio over long periods.
Are Annuities a Good Hedge Against Inflation?
It depends on their structure. A fixed-rate annuity is not a good way to hedge against inflation as both the principal and interest payments will be diminished in real terms. However, a variable rate annuity may be a good hedge if the benchmark rate fluctuates alongside inflation.
The topic of inflation is complex by itself and it gets even more complicated if one tries to understand its implications on an investment portfolio considering the many financial variables that come into play.
However, the assets we have mentioned above should be among the best picks to protect a portfolio’s wealth as much as possible if prices across the economy are increasing at a rapid rate.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.