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Inflation happens when the value of money decreases, causing prices for goods and services to go up. It’s a normal part of an economy, but people can use strategies like inflation hedging to protect against losing buying power.
Inflation hedging also helps safeguard investments. Sometimes, investments may seem profitable, but when inflation is considered, they can be sold at a loss.
Smart investors plan for inflation by choosing assets that do well when prices rise. While traditional bonds are commonly used for income, other investments can also bring in money.
KEY TAKEAWAYS
- Inflation is normal in an economy, but smart investors can prepare for it by choosing assets that do better when prices are going up.
- One tactic is moving money from bonds to stocks, particularly preferred shares.
- Real estate typically does well when prices are rising; investing in Real Estate Investment Trusts (REITs) is a good way to do this.
- Including international stocks or bonds in your portfolio helps protect it from domestic inflation ups and downs.
- Another choice is specialized debt investments such as TIPS (Treasury Inflation-Protected Securities).
- Investing in senior secured bank loans is another method to earn higher returns while shielding yourself from potential price drops if interest rates increase.
Here are five types of assets to consider for guarding against inflation. They include stocks, bonds, and other investment options. Each has its level of risk, but all are possible choices for individual investors.
1. Reallocate Money Into Stocks
If inflation comes back, it usually hurts the bond market but can boost the stock market. Consider moving 10% of your investment from bonds to stocks to benefit from this potential change.
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Warning: “A 60/40 stock/bond portfolio is a mix of stocks and bonds seen as safe and conservative. An example of this type of portfolio is the Dimensional DFA Global Allocation 60/40 Portfolio (I) (DGSIX).”
“Consider buying preferred stocks as an option. These stocks are easy to sell and offer higher returns than many bonds. They may also hold their value better when inflation rises.
Another option is utility stocks, which follow a predictable pattern in the market and provide steady dividends. Their prices tend to move in line with the economy.”
2. Diversify Internationally
“American investors usually focus on U.S. stocks and bonds, but this can be expensive in the long run, especially during inflation. To protect against this, it’s smart to consider investing internationally.
Countries like Italy, Australia, and South Korea have economies that don’t always move in sync with the U.S. Adding stocks from these countries can help balance your portfolio during U.S. economic ups and downs. Bonds from foreign issuers can also offer stable returns even if inflation rises at home.
Consider exchange-traded funds (ETFs) or mutual funds for easy international investing. These are affordable options compared to buying individual foreign stocks. If you already have S&P 500 index funds, consider adding an international index fund to diversify your investments.”
21%
“Many U.S. investors mainly invest in domestic stocks and bonds, even though international markets make up 60% of the global public capital markets. This tendency is called ‘home-country bias.'”
3. Consider Real Estate
“Investing in real estate offers several benefits. Real estate has inherent value and generates steady income from rent payments. It’s also a reliable way to protect against inflation because the demand for homes remains constant regardless of economic conditions. As inflation increases, so do property values, allowing landlords to charge higher rents.”
“While real estate is a valuable asset, it’s difficult to convert into cash quickly. A good alternative is investing in real estate investment trusts (REITs), which are more flexible investments that can be easily bought and sold in the markets. REITs are companies that own and manage various types of properties like commercial buildings, homes, and industrial spaces. They generate income from rents and leases, often offering higher returns than bonds. One major advantage is that REIT prices are less affected by rising interest rates because their operating costs stay stable. An example of a REIT with diverse real estate exposure and low fees 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 keep up with inflation. They’re backed by the U.S. government, making them very safe investments.
These bonds are tied to the Consumer Price Index, which adjusts their value. TIPS pays interest twice yearly based on a fixed rate applied to the adjusted value. The principal increases during inflation and decreases during deflation. TIPS are available in three timeframes: five-year, 10-year, and 30-year.
However, there are risks with TIPS. They’re sensitive to changes in current interest rates, so if you sell before they mature, you might lose some money.”
FAST FACT
“TIPS’ returns in the secondary market have significantly decreased since 2018.”
5. Buy Bank Loans
Certain businesses can do well when prices are rising during inflation. For instance, banks can make more money because they earn higher interest rates and profit from increased loan prices.
Investing in senior secured bank loans is a smart way to earn better returns while safeguarding against a price drop if interest rates increase. However, keep in mind that it might take some time for the value of loans to increase as rates rise. An example of this investment is the Lord Abbett Floating Rate Fund (LFRAX).
Tip: Many of these investments can be complicated, so beginners may find it better to invest in them through a mutual fund or exchange-traded fund (ETF). For instance, the Vanguard Global Ex-U.S. Real Estate Index (VNQI) gives you a wide range of property investments worldwide. The iShares TIPS Bond ETF (TIP) follows the performance of inflation-protected U.S. Treasury bonds. If you’re interested in lower-grade corporate loans, the Lord Abbett Floating Rate Fund (LFRAX) could be a good option.
FAQS
1. What Is Historically the Best Hedge Against Inflation?
Ans: 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. Harvey, Campbell R, and Claude B. Erb, “The Golden Dilemma.” Financial Analyst Journal, vol. 69, no. 4, July-August 2013, pp. 10-42.
Many experts believe that stocks are a great way to safeguard your investments in the long run, especially during sudden increases in inflation. When inflation rises, it often means people are spending more, and the economy is expanding, which can lead to faster growth in corporate earnings. Despite occasional fluctuations, historical data shows that the stock market (like the S&P 500) has increased by an average of 10% yearly over the past century.
2. Is Gold a Good Hedge Against Inflation?
Ans: Gold has long been seen as a way to protect against inflation because it tends to hold its value better than paper money during high inflation.
When inflation goes up, the value of gold usually goes up, too. However, gold isn’t a perfect solution for inflation protection. Its prices can be influenced by many other factors, causing them to fluctuate a lot from year to year. This means that its returns after adjusting for inflation can also vary.
Looking at different periods like one year, five years, ten years, 15 years, and 20 years, the changes in gold’s returns haven’t always been directly linked to inflation rates.
3. Is Bitcoin a Strong Hedge Against Inflation?
Ans: Gold is often considered a good way to protect against inflation because it usually holds its value better than paper money, like the dollar, during high inflation.
When inflation goes up, the value of gold typically increases, too. But gold isn’t a perfect way to hedge against inflation. Other things can affect its prices, causing them to go up and down a lot from year to year. This means the returns you get from gold after considering inflation can also vary. In fact, over the last year, five years, ten years, 15 years, and 20 years, the changes in the returns from gold haven’t always been because of inflation rates.
4. Is Bitcoin a Strong Hedge Against Inflation?
Ans: In theory, bitcoin could be a good way to protect against inflation. When prices rise, investors often turn to safe-haven investments like gold and real estate, which are scarce or don’t depend on paper money. Bitcoin fits this description.
But here’s the problem: bitcoin hasn’t been around for long. It was created in 2009 and has only been traded actively for about a decade. Inflation hasn’t been a big concern for most of its short existence.
Because of this, nobody knows how inflation will affect Bitcoin and its unpredictable behavior. Its performance about inflation has been confusing lately. For example, when inflation worries grew, bitcoin’s value doubled from mid-December 2020 to early January 2021. However, between January 8 and January 11, it suddenly lost 25% of its value with no clear reason.
In May 2021, talk about inflation got stronger. The Federal Reserve hinted at making pandemic policies less lenient and raising interest rates, which made stocks nervous. But Bitcoin took an even bigger hit. On May 19, it ended a month-long drop by closing at $38,390—a 41% decrease from its mid-April peak of $64,829.
5. Can Real Estate Hedge Against Inflation?
Ans: Real estate is a classic way to protect against inflation. Unlike paper assets, it’s a physical asset that tends to hold its value when prices rise. When prices go up, property values also increase, allowing landlords to charge higher rent and earn more income over time.
Another benefit is the concept of “depreciating debt.” This means that the cost of mortgage payments for real estate owners decreases over time. For example, if your mortgage payment is a fixed $8,333 per month in the first year, it will stay the same nominally—$100,000 annually—but may only be worth $80,000 in the 10th year if there’s been ongoing inflation.
All of these factors make real estate a valuable safeguard during inflation.
The Bottom Line
Inflation is a common risk for all investors because money often loses its worth over time, and the inflation rate in an economy can vary based on what’s happening at the moment.
But there are ways to protect yourself from inflation. Some investments and asset classes are designed to do just that. By monitoring these assets and buying them when inflation occurs, you can strengthen your portfolio no matter what’s happening in the economy.
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