If your money isn't moving forward, it's falling back. That's due to inflation, which is almost always with us. Inflation is the term used to describe the steady rise of prices for goods and services that affects all areas of the economy. Over time, inflation can erode the purchasing power of your dollar, and also chip away at your investment returns. But with some foresight and planning, it's possible to protect your money. The solution is investing for inflation — choosing investments that will give you a return greater than the current rate of inflation — or at least keep up with it. Here's how investors can protect themselves from rising prices, and which investments make the best inflation hedge.
Understanding inflation
Inflation refers to rising prices on goods and services across an economy over a period of time.
We measure inflation with the "inflation rate," calculated as a percentage of change of a price index (a representative sampling of goods and services) from one year to the next. In the US, the most commonly used price index is the consumer price index (CPI), but sometimes economists will also use the producers price index (PPI) and personal consumption expenditures (PCE) price index.
Inflation below 2.3% is considered low. It's considered mild between 2.3% and 3.3% and high between 3.3% and 4.9%. Inflation above 4.9% is considered to be very high.
Inflation isn't all bad. Economists like to see a low, steady rise in prices, because it means a healthy economy: Companies are producing, consumers are buying, business and employment and wages are all up. Currently, the US Federal Reserve targets an average annual inflation rate of 2%.
How inflation reduces the buying power of your money
Low inflation may be good for the economy, but it's bad for your wallet. "If annual inflation rates hit 5%, a dollar will only be worth $0.95 cents the following year," says Mark Williams, master lecturer in finance at Boston University's Questrom School of Business.
And it's not just cash that loses value.
Williams notes that those with low-interest bank accounts effectively lose money during periods of inflation because the interest they pay is eaten up by the decline in value. Indeed, any investment that generates a fixed rate of return or interest will see diminished returns in real dollars during inflation.
So while inflation impacts all investors, it's especially tough on income-oriented investors.
What types of assets are good for beating inflation?
Several asset classes in particular lend themselves to inflation-oriented investing.
Appreciation-oriented assets: Go for investments that offer growth, or appreciation — not simply income. Company stock is a prime example.
Real assets: Inflation devalues nominal assets, like CDs and traditional bonds, because they're priced based on the fixed interest they pay, which will lose value when inflation is increasing. In contrast, real assets are tangible things with fundamental value. So their worth floats up together with inflation.
Variable interest-rate assets: If something pays a fixed rate, you'll lose money in an inflationary environment. Assets with fluctuating interest rates give your money more of a fighting chance, as they'll also rise with inflation.
Which investments make good inflation hedges?
Certain specific investments do well when inflation is climbing. Choosing among these assets should reflect your own goals, and also how severe the inflationary climate is.
1. Stocks
In general, returns on stocks beat inflation. Rising prices can mean more profit for companies, which in turn boosts share prices. No guarantees, of course, but over the long term, the stock market has historically provided returns that beat inflation. Passive index investing is the easiest way into stocks, and doesn't rely on an aptitude for stock-picking. Technology and other growth stocks, which outperform the overall market, make the most solid hedges against inflation. Consumer goods companies and others in the defensive sector, which produce basics people need, also do well.
2. Commodities
"Commodities tend to have outsized returns during times of high inflation," says Adem Selita, CEO of the Debt Relief Company. Commodities are a type of real asset, things like crops, raw materials, or natural resources. Their prices go up those of other goods or services that use those goods. In particular, precious metals like gold and silver have long been considered an inflation hedge. As physical assets, both gold and silver have intrinsic worth, unlike the dollar or other currencies. Other inflation hedges include energy commodities, like oil and gas.
3. Real estate
Real estate is both a real asset and an appreciation-oriented one. Like commodities, land and property values tend to rise alongside inflation. If you're not ready to buy actual property, you can still invest in real estate through a real estate investment trust (REIT). These are publicly traded portfolios of properties; although technically securities, they are influenced by real estate trends.
4. Alternative investments
Williams notes that some other tangible assets, such as fine art, vintage cars, and other collectibles, also tend to work well as a hedge against inflation. Again, these are real assets that have intrinsic value to collectors. Although their prices can be hard to predict, the value of these items is expected to appreciate over time, providing returns greater than the inflation rate.
Quick tip: Cryptocurrencies, like Bitcoin and Ethereum, may also protect against inflation because there is a cap on their supply. But since cryptocurrencies are so new, dating back to 2010, it's not clear how they'll perform during times of high inflation — they haven't been around in that sort of environment.
5. US Treasury Inflation-Protected Securities (TIPS)
Most bonds are not good choices to hedge against inflation. The reason is that these investments pay a fixed rate of interest throughout their years- or decades-long lifespans. Their prices on the secondary market might change, but the interest rate they pay is typically not adjusted.
But some bonds, like US Treasury Inflation-Protected Securities (TIPS), have interest rates that are indexed to inflation. That means that their interest payments go up with the inflation rate — and down with deflation — ensuring the payments' worth isn't too badly eroded.
Because they're backed by the US government, TIPs are highly safe, and a good choice for conservative investors.
You can also use debt to deal with inflation
Debt may seem like the opposite of an investment. But incurring it can also be a good financial move when inflation is rampant.
Selita notes that inflation makes it cheaper to service — that is, pay — some types of debt, as long as it has a fixed interest rate. In the same way that inflation eats away at the value of your cash, it also eats away at the value of your loan. This benefits individuals that have acquired loans or mortgages in the past, before the period of inflation set in.
For example, $1 in 1990 is equivalent to about $2 today, so a $1,000 mortgage payment 30 years ago would be worth about $2,000 now. But after all that time, you'd still be paying $1,000 per month. So the value of what you need to pay is reduced by about half. Effectively, you're paying half as much each month to service the debt.
If you can refinance, try changing your loan or mortgage to a fixed rate rather than a variable rate. That will leverage inflation to your advantage.
The financial takeaway
Investing for inflation is essential for protecting your wealth.
Inflation can erode your savings. So, while keeping some cash handy is great for financial security, it's best not to keep too much. If you do, you may find that it just doesn't buy as much as it used to.
Instead, plan for inflation by making your money earn. Choose an investment strategy that's likely to give you a return that at least keeps up with the inflation rate. Look for assets that appreciate, that have a fundamental value of their own, or that pay interest at a fluctuating rate.
By keeping up with inflation, you can maintain the value of your money. And maybe even grow it.
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Article initially appeared on businessinsider.com
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