As an investor, one of your objectives is to outpace the ever-increasing cost of living. The most effective way to protect yourself against the decreasing buying power of money is to build a portfolio of inflation hedges. This guide takes an in-depth look at the various asset classes that retain their value during inflation.
What is an Inflation Hedge?
Inflation is the general and ongoing rise in the prices of general goods and services, such as housing, food, clothing, and transport. Economic factors driving inflation include:
- Rising production costs (cost-push inflation)
- Growing demand for goods and services (demand-pull inflation)
An inflation rate of around 2% indicates a healthy, growing economy, and the U.S. Federal Reserve keeps inflation in check through monetary policy.
The most significant effect of inflation is that it erodes the purchasing power of a currency. In other words, the money you save today will be less valuable tomorrow. The money you have in the bank may earn interest but not fast enough to offset the loss resulting from inflation.
An inflation hedge is an asset investment that maintains its value or appreciates over time, preventing a loss in the currency’s buying power.
Gold is the traditional inflationary hedge. Metal coin debasements resulted in inflation in Egypt from 221 to 204 BC and in China from 960 to 1279. During these inflationary periods, gold successfully preserved investors’ purchasing power.
As a physical, real, and chemically stable metal, gold is an asset that retains value as an alternative currency. Gold investment options to hedge against inflation include the purchase of gold bullion, coins, and jewelry.
Despite gold’s ability to retain value, it is not perfect as an inflationary hedge. When inflation rises, central banks respond with contractionary monetary policy, which includes an interest rate increase. Rising interest rates are one of the factors pushing gold prices down.
Another drawback of gold as an investment asset is that it doesn’t pay any yields. As interest rates increase, so do the opportunity costs of investing in gold.
Rental property, in particular, is a viable inflationary hedge. Rental and lease agreements typically stipulate that a property’s monthly income should increase annually to keep pace with inflation.
In some cases, the annual rental increase can be as high as 10%, outperforming general price level increases by seven to eight percent. If you buy a rental property today, you can rest assured that your rental income’s buying power will remain the same for the time to come.
You can reasonably expect a rental property’s value to appreciate at a higher rate than inflation as well. However, it is critical to purchase a rental at the right price. Proper and regular maintenance is also critical to ensure optimal value appreciation.
Real Estate Investment Trusts (REITs)
If you don’t want to go through the painful process of buying a property, consider a real estate investment trust (REIT) as an inflationary hedge.
REITs are entities owning and managing real estate to generate profits. The Internal Revenue Service (IRS) requires REITs to pay out 90% of their taxable income to shareholders. As a REIT investor, you gain diverse exposure to the equity market with the potential for sizable returns.
REITs offer an inflationary hedge for the same reasons as conventional real estate investments. However, with REITs, the barriers to entry are significantly lower. A REIT operates like a mutual fund and trades publicly on a stock exchange.
The investment minimums are generally low, and you can become a REIT investor with a capital investment of as little as $500.
60/40 Portfolio Alternatives
During the past few decades, most buy-and-hold portfolios had an asset allocation of 60% equities and 40% bonds.
The 60/40 portfolio was simple, offered optimal diversification, and hedged effectively against volatility and inflation. A 60/40 portfolio also generated a substantive annual average return of 8.8% for nearly a century.
Today, the 60/40 asset allocation is rapidly becoming obsolete. Factors warranting the revaluation of this formula include:
- All-time low treasury yields
- Unreliable returns from bonds
- Rising inflation in the medium term
- Suboptimal diversification from the stock/bond allocation
If you have a 60/40 portfolio, you can improve returns, diversification, and inflationary hedging by replacing government bonds with corporate debt and preferred shares.
Ideally, you should also increase your equity allocation and include alternative investments in your portfolio. The latter has no relationship with stocks or bonds, and they have lower volatility than securities trading publicly. Some alternative assets offer the potential for passive income as well.
Aggregate Bond Index
Bonds are fixed-income instruments representing loans between investors and borrowers. Your portfolio should include bonds, despite the low treasury yields, as they generate returns that keep pace with the market.
Bond index funds invest in bond portfolios with the potential to perform similarly to an underlying index. An aggregate bond index offers optimal diversification and hedging against inflation. This option is also suitable for beginner investors who don’t have the time or experience to select high-performing bonds.
The most significant drawback of investing in an aggregate bond index is investment depreciation due to rising interest rates. Also, even though bonds are generally stable, they typically generate low returns.
If you are nearing retirement, consider adding an aggregate bond index to your portfolio to safeguard you against inflation and adopt a low-risk, low-reward strategy.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-protected Securities (TIPS) are bonds and fixed income securities the United States government issues to protect against inflation and earn interest payments.
When investing in TIPS, you buy debt that the government issued and receive regular interest on the security’s par value. At the end of the TIPS term, you receive a repayment of the loan’s original value.
Inflation protection is inherent to TIPS. The U.S. Treasury adjusts the face value of the securities annually. The treasury bases this adjustment on the Consumer Price Index, which is one of the measures of inflation.
The annual adjustment ensures that the purchasing power of your TIPS investment remains the same. As a TIPS investor, your earnings are taxable on the federal level.
Commodities are economic goods that meet a basic grade and that are interchangeable with each other. Examples of commodities include raw materials, agricultural products, or energy products such as oil.
Commodities are an asset class, and investors can choose from a wide range of investment vehicles, including exchange-traded funds and mutual funds, to invest in the commodities futures markets.
Investing in commodities holds several benefits, with inflation hedging being the most significant. Other benefits of investing in these assets include a high return potential and portfolio diversification.
The value of commodities tends to increase in an inflationary environment. An increase in the demand for goods and services hikes the equilibrium price of these goods and services.
The commodities as means of production for these goods and services undergo a price increase as well.
Leveraged loans, or collateralized loan obligations (CLOs), fall under an asset class that offers optimal inflation protection. A leveraged loan is a loan by a group of lenders to a company that is a high-risk borrower with a low credit score.
One or more banks structure and administer leveraged loans before syndicating them to institutional investors as a pooled and single security. The investors then receive the debt repayments in terms of the underlying loan agreements.
Leveraged loans are inflation hedges because they generate a floating rate yield. In other words, the rate moves with the market for the duration of the loan term.
The Stock Market
Since 1928, the stock market has generated an average return of around 10% per year while the inflation rate averaged 3%. In other words, the stock market’s growth was 7% higher than the inflation rate. Along with value appreciation, dividends and earnings also grew at a higher rate than inflation.
During inflationary periods, stock market returns tend to decrease. However, by focusing on specific areas within the market, you can reduce your portfolio’s susceptibility to inflation.
Value stocks perform better than growth stocks during times of inflation. A value stock trades at a lower price than the security’s intrinsic value. Its characteristics include a low price-to-earnings ratio, a high dividend yield, and a low price-to-book ratio.
Precious metal stocks also tend to perform well when inflation increases. However, under normal market conditions, the returns these stocks generate are relatively low.
Hedging against inflation is integral to investment risk management. By including the above asset classes in your portfolio, you ensure that your investments keep track of inflation, preventing an ongoing price level increase from eroding your principal value.
Diversification remains a critical investment objective, and your entire portfolio shouldn’t consist of inflation hedges. However, with an inflation increase looming in the mid-term, it is worth considering investments that are immune from its economic effects.