Investing Cash During Inflation: Strategies For Success

Inflation is a tricky time for investors, with rising prices and interest rates impacting the value of money. Investors need to consider how to protect their cash and investments from losing value. While no one can predict market trends, certain investments have been shown to be effective in beating inflation. This includes investing in assets with returns that outpace inflation, such as gold, real estate, stocks, and Treasury Inflation-Protected Securities (TIPS). Diversification is also key, with experts recommending a range of options, from index funds to commodities, to reduce the risk of loss.

Invest in real estate

Real estate has historically been a popular choice during inflation, as it becomes a more useful and popular store of value. It is also a tangible asset, which has traditionally been seen as an inflation hedge.

Rental Properties

Rental properties are a good investment during inflation, as people will opt to rent rather than buy due to high mortgage rates. This increases the demand for rental properties, which results in higher rental rates. Rental properties, therefore, tend to generate high returns during inflation.

Real Estate Investment Trusts (REITs)

REITs are companies that manage real estate assets. They can be a good investment during inflation as they tend to follow the market demands and appreciation similar to that of physical real estate. REITs can also provide steady dividends to small investors.

Commercial Real Estate

Commercial real estate, especially those that operate commercial properties, is a good option during inflation. This is because they tend to have short lease durations and can reset to market rates more frequently.

Residential Properties

Residential properties tend to keep up with inflation over time, and their essential nature makes them rather recession-resistant.

Industrial Properties

Industrial properties are in high demand due to the surge in e-commerce, which has created a need for logistics real estate.

Hotel REITs

Hotels have the shortest "lease" durations of any commercial property type, as they can change their room rates daily. With the ability to raise prices with inflation, hotel REITs could be a good investment.

Things to Consider

It is important to note that inflation is not appreciation. Appreciation is the increase of a property's value over time based on demand, not in relation to the currency. Additionally, the increased cost of borrowing debt during inflation can make new construction a difficult investment. Inflation can affect real estate investing both positively and negatively, so it is crucial to do your due diligence and consult a professional.

Diversify with TIPS and I-Bonds

Treasury Inflation-Protected Securities (TIPS) and I-Bonds are government-issued bonds designed to protect investors from inflation. They are an excellent way to diversify your portfolio during inflation.

TIPS and I-Bonds are designed to protect investors from a decline in the purchasing power of their money. The principal value of these bonds rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond. This means that investors receive higher interest or coupon payments as inflation increases.

For example, if an investor owns $1,000 in TIPS with a 1% coupon rate and inflation rises by 2%, the principal will be adjusted to $1,020. The coupon rate will remain at 1%, but it will be multiplied by the adjusted principal amount, resulting in an interest payment of $10.20 for the year.

Benefits of TIPS and I-Bonds

• Inflation protection: TIPS and I-Bonds are designed to safeguard investors against inflation by adjusting the principal amount based on changes in the Consumer Price Index (CPI).
• Safety and stability: These bonds are issued and backed by the US government, making them a lower-risk investment option.
• Regular interest payments: TIPS and I-Bonds provide semi-annual interest payments, which can be beneficial for retirees or those seeking a steady income.
• Capital appreciation potential: As inflation rises, the principal value of these bonds increases, leading to potential capital gains if sold before maturity.
• Tax advantages: The interest income from TIPS and I-Bonds is exempt from state and local taxes, offering tax benefits, especially for investors in high-tax states.
• Diversification: Including these bonds in a portfolio can enhance diversification as they can perform differently from other asset classes that may be negatively affected by rising prices and inflation.
• Market liquidity: TIPS and I-Bonds are highly liquid securities that can be easily bought and sold in the secondary market.

Considerations

When considering TIPS and I-Bonds, it is important to keep the following in mind:

• Lower yield: These bonds typically offer lower yields compared to other types of bonds due to their lower risk.
• Inflation adjustment taxation: The increase in the principal value due to inflation is considered taxable income, even though investors do not receive this amount until the bond matures or is sold.
• Deflation risk: While TIPS and I-Bonds protect against inflation, they offer less benefit during deflationary periods as the principal value adjusts downward.
• Liquidity issues in times of crisis: During financial crises or market stress, the liquidity of these bonds can be impacted, making it harder to sell them.
• Opportunity cost: Investing in TIPS and I-Bonds may involve opportunity costs as investors may forego potentially higher returns from riskier investments.

How to buy TIPS and I-Bonds

TIPS and I-Bonds can be purchased directly from the US government through the TreasuryDirect system or from a bank or broker. They are also available through mutual funds or exchange-traded funds (ETFs) that invest in these bonds and other inflation-linked securities.

Who are TIPS and I-Bonds best suited for?

TIPS and I-Bonds are ideal for conservative investors who prioritize capital preservation and risk minimization. They are also suitable for retirees and those focused on generating a stable income stream, as well as long-term investors concerned about the impact of inflation over extended periods.

Look for high-yield interest rates

When inflation is high, interest rates tend to rise. This is because interest rates are the primary tool used by central banks to manage inflation. As a result, banks start to offer higher interest rates on checking, savings, and certificates of deposit accounts.

While bank account interest rates usually don't beat the rate of inflation, they can help hedge against inflation better than keeping cash at home or in a low-rate account. For example, while the national average annual percentage yield for savings accounts is 0.06%, some financial institutions offer rates of 1.00% or more.

If you're keeping money in a savings account, it's better to stick with established banks. Ken Tumin, founder and editor of DepositAccounts.com, cautioned savers to be "real careful" with financial technology companies partnering with banks for checking and savings accounts and other cash products. "You should go directly to FDIC-insured banks, rather than through fintechs," Tumin said.

Another option for savings is certificates of deposit (CDs). In the current economic climate, you can often get a higher rate for short-term CDs than long-term CDs. While savings account interest is expected to rise, these rates may not match one-year CDs, which have more closely followed the Fed. As of January 4, 2023, one-year CDs were offering an average of 4.81%.

TreasuryDirect Series I savings bonds can also be a good option for short-term savings. These bonds give an interest rate of over 7% on up to $10,000 for a one-year term.

Invest in stocks

While inflation can be challenging for investors, several investments tend to fare well during periods of rising inflation. Here are some things to keep in mind if you're considering investing in stocks during inflation:

Diversification

Diversifying your portfolio is always important, but it becomes even more crucial during inflationary periods. Don't put all your eggs in one basket, as this can help eliminate loss. Include a mix of stocks, bonds, and other asset classes in your portfolio to spread out the risk.

Defensive Stocks

Defensive stocks, such as those in the information technology, pharmaceutical, and biotech sectors, tend to do better during recessionary periods and offer modest dividends. These companies are less sensitive to inflationary pressures and economic cycles, providing stable earnings regardless of the economic environment.

Value Stocks

Value stocks, particularly in the consumer staples space (e.g., food and energy), can be a good choice during inflation. These companies have more pricing power and can increase their prices along with inflation better than other industries. Their demand is also less elastic, meaning people will continue to buy their products even with price increases.

Treasury Inflation-Protected Securities (TIPS)

TIPS are a type of inflation-resistant fixed-income investment. They are Treasury bonds indexed to inflation, which means their value increases with rising prices. This helps protect investors' purchasing power by adjusting to inflation. TIPS can be a good addition to your stock portfolio to hedge against inflation.

Real Estate Investment Trusts (REITs)

REITs are companies that manage real estate assets. They provide an easy way to invest in real estate without actually buying property. REITs can offer stable dividends and are less sensitive to inflation than other investments.

High-Quality Companies with Dividends

Look for established companies that pay dividends, as they can provide a steady income stream during inflation. These companies often have a unique angle or a strong position in the market, allowing them to pass their rising input costs on to customers.

Long-Term Perspective

Remember that investing in stocks during inflation requires a long-term perspective. While there may be short-term fluctuations, historically, stocks have beaten inflation over time. Focus on your long-term investing goals and make adjustments along the way as needed.

In summary, investing in stocks during inflation requires careful consideration and a well-diversified portfolio. By choosing the right sectors, such as defensive and value stocks, and including inflation-protected investments like TIPS and REITs, you can protect your portfolio and potentially generate returns that outpace inflation.

Keep an emergency fund

Keeping an emergency fund is a crucial part of financial planning, especially during inflation. Here are some detailed tips to help you build and maintain an emergency fund:

Determine the Amount

The recommended amount for an emergency fund is generally three to six months' worth of necessary living expenses. This includes essentials such as housing, transportation, insurance, groceries, and basic utilities. However, you may want to adjust this amount based on your personal circumstances. For example, if you own a home or a car that requires frequent repairs, or if you have pets or children, you may want to increase your emergency fund.

Choose the Right Account

It is advisable to keep your emergency fund separate from your other bank accounts. Look for accounts that offer high-yield interest rates, such as high-yield savings accounts or money market accounts. These accounts can provide higher interest rates than traditional savings accounts, helping your emergency fund grow while remaining accessible.

Make Regular Contributions

Building an emergency fund is most effective when contributions are made regularly and automatically. Treat your emergency fund contributions as a line item in your budget, and consider setting up automatic transfers from your checking account or directly from your paycheck. This way, you can gradually build your fund without having to remember to transfer funds manually each time.

Accessibility vs. Temptation

While you want your emergency fund to be accessible, it should not be so easily accessible that you are tempted to dip into it for non-emergencies. Consider keeping your emergency fund in a separate bank from your other accounts, adding a degree of difficulty when accessing the funds. This helps ensure that you only use the money for true emergencies.

Avoid Risky Investments

When it comes to your emergency fund, it is best to avoid volatile or risky investments. Stocks, for example, can be unpredictable, and you may be forced to sell at a loss if you need the money urgently. Instead, opt for more stable and liquid investment options, such as high-yield savings accounts or money market accounts, which provide easier access to your funds without penalties.

Diversification

While diversification is generally recommended for investment portfolios, your emergency fund should ideally be kept in cash or highly liquid assets. This ensures that you can quickly convert your emergency fund into cash without incurring withdrawal penalties or selling at a loss.

In summary, building and maintaining an emergency fund during inflation involves determining the appropriate amount, choosing the right type of account, making regular contributions, balancing accessibility with temptation, avoiding risky investments, and keeping your funds liquid. By following these steps, you can ensure that you have a cushion to fall back on during unexpected financial emergencies.

Frequently asked questions