Understanding Inflation - Part 2
Welcome back! This week, we will begin discussing how you can potentially hedge your finances from inflation. One way to do that is to invest in assets that have historically increased in value over time. Several types of investments can help you hedge against inflation, including:
1. Real Estate: Real estate is a tangible asset that tends to appreciate in value over time. Investing in real estate can protect your money from inflation while earning a steady rental income.
2. Stocks: Stocks represent ownership in a company and can increase in value over time as the company grows and earns more profits. Investing in stocks may benefit from the economy's long-term growth, which may be outpacing inflation.
3. Bonds: Investing in bonds may seem counterintuitive as inflation typically harms fixed-rate debt. That's not the case for inflation-indexed bonds, which offer a variable interest rate tied to the inflation rate.
4. Commodities: Commodities are physical goods, such as gold or oil, that can be used economically. Investing in commodities can help hedge your money against inflation because the price of commodities tends to rise when the value of money decreases.
Let’s look deeper into each of these investment types and how they work.
Real Estate
Real estate is a popular choice because it becomes a more useful store of value amid inflation while generating increased rental income. Investors can buy real estate directly or invest in it by buying shares of a real estate investment trust (REIT) or specialized fund. For an example of how Real estate fared during a particularly persistent outbreak of inflation, we can look to the 1970s.1 In the 1970s, the median home price rose from $23,000 to $55,700, an average annual gain of 9.9%.2 But real estate is also vulnerable to rising interest rates and financial crises, as seen in 2007-2008. And interest rate increases are the conventional monetary policy response to elevated inflation.
Stocks
For a longer-term hedge against inflation, you might consider equities. We'll explain why because we’re sure you have at least one eyebrow raised because of inflation's seeming effect on market volatility. Since 1927, equity prices have grown substantially higher than inflation on a real return basis.3 This is possible because corporate earnings have historically grown faster than inflation. If you're concerned about inflation, consider skewing your portfolio to a higher percentage of equities, especially dividend-paying equities.
While high inflation can cause market volatility, equities, like dividend-paying equities, can provide a quarterly return to counteract inflation through those dividends, regardless of whether the market is up, down, or flat.3
Investment firm Hartford Funds performed research that showed that equities outperformed inflation 90% of the time when inflation was low and on the rise.4 The energy sector, including oil and gas companies, tends to perform well during high inflationary periods, and we all know why too well! 4 Equity REITs (real-estate investment trusts) may also help mitigate the impact of rising inflation. They outperformed inflation 66% of the time and posted an average real return of 4.6%.4 This makes sense too. Equity REITs own real-estate assets and may provide a partial inflation hedge via the pass-through of price increases in rental contracts and property prices.
Bonds
Investing in bonds may seem counterintuitive as inflation is typically harmful to fixed-rate debt. That's not the case for inflation-indexed bonds, which offer a variable interest rate tied to the inflation rate. In the United States, Treasury Inflation-Protected Securities (TIPS) are popular and track the Consumer Price Index (CPI).5
When the CPI rises, so does the value of a TIPS investment. Not only does the base value increase, but since the interest paid is based on the base value, the interest payments also increase. Inflation-indexed bonds can be accessed in a variety of ways. Direct investment in TIPS, for instance, can be made through the U.S. Treasury or via a brokerage account. They are also held in some mutual funds and exchange-traded funds.
For a more aggressive play, consider junk bonds. High-yield debt—as it is officially known—tends to gain in value when inflation rises, as investors turn to the higher returns this riskier-than-average fixed-income investment offers.
Commodities
When inflation picks up, investors often turn to tangible assets likely to rise in value. For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals—causing prices to rise as inflation rises. Gold can also be purchased directly from a bullion or coin dealer or indirectly by investing in a mutual fund or exchange-traded fund (ETF) that owns gold. You can also get exposure to a commodity by buying the shares of its producers directly or indirectly through an ETF or specialized mutual fund.
Commodities include raw materials and agricultural products like oil, copper, cotton, soybeans, and orange juice. Commodity prices tend to rise alongside the prices of finished products made from those commodities in inflationary environments.
It is important to remember that investing always carries some risk. While we are not making specific recommendations, we encourage you to reach out if you want to discuss the appropriateness of any of these ideas in your financial plan.
If you found this blog helpful and think your friends and family can benefit, we encourage you to share it with them. Next week, we will talk about inflation and your savings.
Sources:
1 National Bureau of Economic Research. "Inflation and the Price of Real Assets," Page 2.
3 Best Investments to Hedge Against Inflation.
4 Which Equity Sectors Can Combat Higher Inflation?
5 TreasuryDirect. "Treasury Inflation-Protected Securities (TIPS)."
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in the price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.