In this article, I want to discuss about investment strategies against inflation. Because of excessive money printing after the pandemic, many people believe that the inflation rate in the United States is going to pick up. I am going to introduce four classes of investments that are normally used to hedge against inflation.
This article consists of three segments:
- First, I am going to quickly discuss about inflation.
- Then, I am going to share with you the general idea of how you can hedge your portfolio against inflation.
- In the third part, I am going to share the four common asset classes that you should consider using as a hedge against inflation.
Inflation is defined as the decline in the purchasing power of the currency over time. In other words, in an inflationary environment, the purchasing power of the money that you have today is going to be lower next year.
This usually happens when the money supply, in other words, the amount of currency available to people, is increased without a corresponding increase in the volume of products and services available for purchase. This is very much similar to what has happened in the United States.
The government has been printing money and increasing the money supply, which is going to result in inflation. This chart shows you the Consumer Price Index(CPI) posted on the U.S. Bureau of Labor Statistics website.
The Consumer Price Index measures the average change in prices over time that consumers pay for a basket of goods and services. As you can see, the CPI index has gone up by 4.2% in the past 12 months.
Protection against inflation
The ideal investments for hedging against inflation include those that maintain their value during inflation or that increase in value over that period of time. We know that inflation increases the cost of products and services.
Any investment that stands to benefit from these price jumps or is resilient to price hikes is considered a good hedge against inflation. With any diversified portfolio, keeping inflation-hedged asset classes on your watch list is critical. Gradually investing in these types of assets over time can help your portfolio thrive when inflation hits.
Common anti-inflation assets include TIPS, various real estate investments, commodities, and precious metals. Let’s take a look at each of these asset classes in more detail.
Asset Classes to Hedge Against Inflation
(1) Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities or TIPS for short are the most straight forward way to protect against a potential increase in inflation.
What are Treasury Securities?
Treasury bonds are debt securities issued by the United States Department of the Treasury to help pay for the U.S. government’s borrowing needs. In other words, investing in U.S. treasury bonds is analogous to lending money to the U.S. government.
This is how Treasury bonds work. As shown in above picture:
- First, you lend money to the government.
- Second, the government pays you interest rates in the form of biannual coupons.
- Third, after the end of the lending period, the government gives you back your principal.
The government gets to use your money during that period and compensates you by paying interest every six months. Regular treasury bonds have fixed coupon payments. Therefore, the amount of interest rate that you receive will not change over time, even when inflation goes up.
This is where TIPS comes into play. The coupon payments of TIPS are tied to changes in inflation. So, in inflationary periods, TIPS pays out more interest. As a result, they are the most direct hedge against inflation among the options here. These securities are ideal instruments for people looking for some inflation insulation.
(2) Real Estate Securities
Another type of asset class that provides protection against inflation is real estate. Property prices and rental income tend to rise when inflation rises. That is because inflation raises the construction costs, and builders of homes generally shift higher construction costs onto buyers.
Therefore, one way of protecting your portfolio against inflation is to invest in real estate. You do not have to necessarily buy a rental property to participate.
Mutual funds or ETFs that provide broad exposure to national and international commercial and residential real estate markets are good options to consider.
Another great alternative is to invest in real Estate Investment Trusts (REITs), which are companies that own and operate income-producing real estate. A REIT consists of a pool of real estate that pays out dividends to its investors. Investing in REITs gives you exposure to real estate without you having to purchase or manage a property.
Commodities are produced or extracted products, often natural resources or agricultural goods, that are often used as inputs into other processes.
Investors break down commodities into two categories: hard and soft.
- Hard commodities require mining or drilling to find, such as metals like copper and aluminum, and energy products like crude oil, natural gas, and unleaded gasoline.
- Soft commodities refer to things that are grown or ranched, such as corn, wheat, soybeans, and cattle.
Because commodity prices typically rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation, but commodities usually do.
To hedge your portfolio against inflation, you do not need to necessarily buy these commodities and store them. You can simply get exposure to these commodities through exchange-traded funds (ETFs) and mutual funds.
For example, you can buy ETFs that specialize in commodities or buy shares of stock in companies that produce commodities.
(4) Precious Metals
Precious metals are thought to be a good portfolio diversifier and hedge against inflation. That is because precious metals have limited supply and, as a result, can not be devalued when the government prints money and increases the money supply.
Note that gold, perhaps the most well-known such metal, is not the only one out there for investors.
Silver, platinum, and palladium are all commodities that can be added to your precious metals portfolio, and each has its own unique risks and opportunities.
I should note that the performance of precious metals under inflationary situations has not been super consistent despite what their proponents want you to believe. Therefore, as an inflation hedge, precious metals are my least favorite of the four types of assets that I discussed in this article.