How to Hedge Against Inflation
Inflation measures how much an economy rises over time, comparing the average price of a basket of goods from one point in time to another. Understanding inflation is an important element of investing.
The Bureau of Labor Statistics CPI Inflation Calculator shows that $5.00 in September 2000 has the purchasing power equal to $7.49 in September 2020. To continue to afford necessities, your income must pace or rise above the rate of inflation.
For investors, inflation represents a real problem. If your investment isn’t growing faster than inflation you could technically end up losing money instead of growing your wealth. That’s why many investors look for stable and secure places to invest their wealth. Ideally, in investment vehicles that guarantee a return that’ll outpace inflation.
These investments are commonly known as “inflation hedges”.
5 Top Inflations Hedges to Know
Depending on your risk tolerance, you probably wouldn’t want to keep all of your wealth in inflation hedges. Although they might be secure, they also tend to earn minimal returns. You’ll unlikely get rich from these assets, but it’s also unlikely you’ll lose money.
Many investors turn to these secure investments when they notice an inflationary environment is gaining momentum. Here’s what you should know about the most common inflation hedges.
Some say gold is over-hyped, because not only does it not pay interest or dividends, but it also does poorly when the economy is doing well. Central banks, who own most of the world’s gold, can also deflate its price by selling some of its stockpile. Gold’s popularity might be partially linked to the “gold standard”, which is the way countries used to value its currency. The U.S. hasn’t used the gold standard since 1933.
Still, gold’s stability in a crisis could be good for investors who need to diversify their assets or for someone who’s very risk-averse.
If you want to buy physical gold, you can get gold bars or coins — but these can be risky to store and cumbersome to sell. It can also be hard to determine their value if they have a commemorative or artistic design or are gold-plated. Another option is to buy gold stocks or mutual funds.
Is gold right for you? You’ll need to determine how much risk you’re willing to tolerate with your investments since gold offers a low risk but also a low reward.
2. Real Estate Investment Trusts (REITs)
Buying real estate can be messy — it takes a long time, there are many extra fees, and at the end of the process, you have a property you need to manage. Buying REITs, however, is simple.
REITs provide a hedge for investors who need to diversify their portfolio and want to do so by getting into real estate. They’re listed on major stock exchanges and you can buy shares in them like you would any other stock.
If you’re considering a REIT as an inflation hedge you’ll want to start your investment process by researching which REITs you’re interested in. There are REITs in many industries such as health care, mortgage or retail.
3. Aggregate Bond Index
A bond is an investment security — basically an agreement that an investor will lend money for a specified time period. You earn a return when the entity to whom you loaned money pays you back, with interest. A bond index fund invests in a portfolio of bonds that hope to perform similarly to an identified index. Bonds are typically considered to be safe investments, but the bond market can be complicated.
If you’re just getting started with investing, or if you don’t have time to research the bond market, an aggregate bond index can be helpful because it has diversification built into its premise.
Of course, with an aggregate bond index you run the risk that the value of your investment will decrease as interest rates increase. This is a common risk if you’re investing in bonds — as the interest rate rises, older issued bonds can’t compete with new bonds that earn a higher return for their investors.
Be sure to weigh the credit risk to see how likely it is that the bond index will be downgraded. You can determine this by reviewing its credit rating.
4. 60/40 Portfolio
Financial advisors used to highly recommend a 60/40 stock-bond mix to create a diversified investment portfolio that hedged against inflation. However, in recent years that advice has come under scrutiny and many leading financial experts no longer recommend this approach.
Instead, investors recommend even more diversification and what’s called an “environmentally balanced” portfolio which offers more consistency and does better in down markets. If you’re considering a 60/40 mix, do your research to compare how this performs against an environmentally balanced approach over time before making your final decision.
5. Treasury inflation-protected securities (TIPS)
Since TIPS are indexed for inflation they’re one of the most reliable ways to guard yourself against high inflation. Also, every six months they pay interest, which could provide you with a small return.
You can buy TIPS from the Treasury Direct system in maturities of five, 10 or 30 years. Keep in mind that there’s always the risk of deflation when it comes to TIPS. You’re always guaranteed a minimum of your original principal at maturity, but inflation could impact your interest earnings.
The Bottom Line
Inflation represents a real risk for investors as it could erode the principal value of your investment. Make sure your investments are keeping pace with inflation, at a minimum.
Inflation hedges can protect some of your assets from inflation. Although you don’t always have to put your money in inflation hedges, they can be helpful if you notice the market is heading into an inflationary period.
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Article initially appeared on goodfinancialcents.com
Credit: goodfinancialcents.com, Merrill Lynch, NYSE
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