Hedging Against Inflation: Strategies For Protecting Your Investments

Inflation is a decrease in the purchasing power of money, and it poses a significant risk to the ability to keep up with the cost of goods and services over time. It is therefore important to find the right strategies and investments to hedge against it.

- Invest in Treasury Bonds: Treasury securities are debt instruments taken out by governments, which pay interest and return the principal. US Treasuries are popular as investments because they retain a high credit rating and generate a consistent income for investors. Treasury Inflation-Protected Securities (TIPS) are a type of US Treasury bond designed to increase in value to keep pace with inflation.

- Purchase Gold and Precious Metals: Gold and precious metals have historically preserved purchasing power. They are easily traded in liquid markets and are durable and malleable.

- Fund a High-Yield Savings Account: High-yield savings accounts offer significantly higher interest rates than traditional savings accounts.

- Invest in the Stock Market: While inflation can negatively impact stock prices, historically, long-term investing in stocks has benefited investors looking to build wealth.

- Buy Alternative Investments: Options include real estate, commodities, cryptocurrencies, and more.

Invest in stocks

Stocks are a good long-term vehicle for hedging against inflation. While the stock market might get hit by worries of inflation in the short term, the best companies can power through it with their better economics.

If you expect inflation to persist, it can be a good time to be a borrower. If you borrow at a fixed interest rate, you’re effectively repaying your debt with cheaper dollars in the future.

Reallocate Money Into Stocks

If inflation returns, it's generally bad for the bond market, but it could be good for the stock market. Consider reallocating a portion of your portfolio from bonds to equities to take advantage of this possible trend. For example, a 60/40 stock/bond portfolio is considered a safe, conservative mix. However, keep in mind that compared to an all-equity portfolio, a 60/40 portfolio will underperform over the long term due to the effects of compounding interest.

Diversify Internationally

American investors tend to focus on stocks and bonds in the U.S. However, increasing international exposure can be a good strategy to hedge against inflation. Major economies like Italy, Australia, and South Korea do not rise and fall in tandem with U.S. market indices. Adding stocks from these countries can help protect your portfolio from domestic economic cycles.

Focus on Companies with Pricing Power

When investing in stocks to hedge against inflation, look for companies with pricing power. These are companies that can raise prices for their customers when their costs rise, allowing them to continue growing profits despite inflation.

Consider the S&P 500 Index

The S&P 500 has a high concentration of technology and communication services businesses, which are capital-light industries that should theoretically be inflation winners. However, keep in mind that the S&P 500 gives higher weights to larger companies, and it does not provide exposure to small-cap companies, which have historically produced higher returns.

Diversify internationally

Diversifying your portfolio internationally is a great way to hedge against inflation. Here are four to six paragraphs explaining this strategy in detail:

The Benefits of International Diversification

American investors often favour investing in US stocks and bonds, but this can be a costly strategy, especially during inflationary periods. Increasing your international exposure can help protect your portfolio from the negative effects of domestic inflation. By investing in a variety of international markets, you can reduce the impact of inflation on your investments.

Major Economies to Consider

Several major economies, such as Italy, Australia, and South Korea, do not move in tandem with US market indices. By adding stocks from these or similar countries to your portfolio, you can hedge against domestic economic cycles. For example, if the US experiences inflation, other countries may not be facing the same level of inflation, thus providing a buffer for your investments.

International Bonds

Bonds from foreign issuers can provide investors with exposure to fixed income that may be less affected by domestic inflation. These bonds offer a steady income stream that can help offset the impact of rising prices in your home country. International bonds are also a great way to diversify your portfolio and reduce the overall risk.

Exchange-Traded Funds (ETFs) and Mutual Funds

ETFs and mutual funds are excellent, low-cost options for diversifying your investments internationally. These funds provide access to a diverse range of international markets and can be less costly compared to purchasing individual stocks or American Depositary Receipts (ADRs). If you already hold S&P 500 index funds, consider adding an international index fund to further diversify your portfolio.

Other Considerations

Keep in mind that international diversification may come with additional risks, such as currency fluctuations and political or economic instability in the countries you invest in. It is important to carefully research and understand the markets you are investing in. Additionally, seek professional financial advice before making any significant investment decisions.

Consider real estate

Real estate is a tangible asset and one of the time-honoured inflation hedges. As an asset with intrinsic value, it provides a consistent income through dividends. It is a good hedge against inflation since there will always be a demand for homes, regardless of the economic climate.

As inflation rises, so do property values, and therefore the amount a landlord can charge for rent. This results in the landlord earning a higher rental income over time, helping to keep pace with the rise in inflation. This makes real estate income one of the best ways to hedge an investment portfolio against inflation.

Real estate also benefits from the phenomenon of "depreciating debt". The cost of the real estate owner's mortgage payments declines over time. For example, if your mortgage payments are $8,333 per month during the first year of your loan, they will remain nominally the same, but may only be worth $80,000 in the tenth year if there has been sustained inflation during that period.

Real estate investments also benefit from rising inflation as the equity on the property increases but the fixed-rate mortgage payments remain the same.

An alternative to buying property is to invest in real estate investment trusts (REITs). REITs are companies that own and operate portfolios of commercial, residential, and industrial properties. They are more liquid investments that can be bought and sold easily on the markets. They often pay higher yields than bonds, and their prices are not as affected when interest rates rise because their operating costs remain largely unchanged.

However, it is important to note that real estate is an illiquid asset, and transactions costs are considerably higher compared to purchasing shares of stock. Real estate investments also require management and maintenance, and these costs can add up quickly. Finally, real estate investing involves taking on a great deal of financial and legal liability.

Buy gold and precious metals

Gold and other precious metals are often seen as a safe-haven investment to hedge against inflation. Gold is a tangible asset that tends to hold its value, unlike paper currencies that lose purchasing power when inflation is high.

Gold has been a store of value for thousands of years and has real-world uses, such as in jewellery and electronics. It has a limited supply, which further adds to its value.

Gold's value as an inflation hedge is demonstrated by the fact that during periods of high inflation, such as in the 1970s, it generated impressive returns. For example, between 1974 and 2008, there were eight years of high inflation in the US, and during those years, gold prices rose by an average of 14.9% year-on-year.

However, gold's performance as an inflation hedge is not always consistent. For example, from 1980 to 1984, when annual inflation averaged 6.5%, gold prices fell by 10% each year.

Gold's mixed record as an inflation hedge may be due to other factors influencing its price, such as supply, investor sentiment, and trading trends in futures markets.

Gold is also a volatile asset, and investing in it may require long periods to realise profits. Additionally, gold does not provide any yield, and when central banks raise interest rates during inflationary periods, holding gold becomes less attractive compared to assets that offer yields.

Despite these drawbacks, gold can still be a valuable addition to an investment portfolio due to its low or negative correlation with stocks and bonds, providing diversification benefits.

For those interested in investing in gold, there are several options:

• Buying physical gold, such as bullion, bars, or coins, and storing it in a safe or bank vault.
• Investing in gold exchange-traded funds (ETFs), such as the SPDR Gold Shares (GLD), which is the largest physically-backed gold ETF.
• Trading gold futures contracts, which provide significant leverage.
• Buying shares of individual gold mining companies or gold mining ETFs, such as the VanEck Gold Miners ETF (GDX).

Gold may not be a perfect hedge against inflation, but it can offer some protection against rising prices and is particularly valuable during times of economic uncertainty.

Invest in the bond market

The bond market is a good option for investors looking to hedge against inflation. While inflation can negatively impact bond prices, there are ways to mitigate this risk. Here are some strategies for investing in the bond market to protect against inflation:

US Treasury Bonds

US Treasury bonds are often sought by investors for the income they provide. They are debt instruments issued by the US government that pay interest and return the principal. US Treasuries are considered safe investments because they have a high credit rating and consistently generate income for investors. The value of US Treasury bonds is influenced by interest rates, which change in response to inflation. When interest rates rise, the value of US Treasury bonds falls, and vice versa. As a result, shorter-term bonds are generally safer investments than longer-term bonds when interest rates are rising.

Treasury Inflation-Protected Securities (TIPS)

TIPS are a type of US Treasury bond designed to protect investors from high inflation. They periodically adjust the principal amount based on the inflation rate to preserve the purchasing power of the bond. TIPS are a popular choice for those seeking to maintain the value of their investment in government debt.

Floating-Rate Bonds

Floating-rate bonds, also known as floating-rate notes (FRNs), are another option for investors. Unlike traditional bonds that offer a fixed payment, floating-rate bonds have a variable interest rate that adjusts periodically based on a reference rate, such as the federal funds rate or LIBOR. This feature makes them less sensitive to interest rate changes caused by inflation. Floating-rate bonds can be purchased through bond ETFs or mutual funds, providing both inflation protection and diversification.

Bloomberg Aggregate Bond Index

The Bloomberg Aggregate Bond Index is a market index that tracks the performance of the US bond market, including government, corporate, taxable, and municipal bonds. Investing in this index provides exposure to a diverse range of bonds. However, it is important to note that the index is weighted towards companies and agencies with the most debt and has a heavy focus on US government bonds, which may impact its diversification.

Diversification

Diversifying your bond holdings can also help hedge against inflation. This can be achieved by investing in a mix of short-term and long-term bonds, domestic and international bonds, and bonds from different sectors. By spreading your investments across various types of bonds, you reduce the risk associated with any single bond or group of bonds.

High-Yield Savings Accounts

While not technically part of the bond market, high-yield savings accounts can offer a way to protect your cash from inflation. These accounts typically provide higher interest rates than traditional savings accounts, helping to offset the impact of inflation on your savings. However, they usually require a minimum balance to obtain favourable rates.

Frequently asked questions