Inflation measures how much an economy rises over time, comparing the average price of a basket of goods from one point in time to another. Understanding inflation is an important element of investing.
The Bureau of Labor Statistics CPI Inflation Calculator shows that $5.00 in September 2000 has the purchasing power equal to $7.49 in September 2020. To continue to afford necessities, your income must pace or rise above the rate of inflation. If your income didn’t rise along with inflation, you couldn’t afford that same pizza in September 2020 — even if your income never changed.
For investors, inflation represents a real problem. If your investment isn’t growing faster than inflation you could technically end up losing money instead of growing your wealth. That’s why many investors look for stable and secure places to invest their wealth. Ideally, in investment vehicles that guarantee a return that’ll outpace inflation.
These investments are commonly known as “inflation hedges”.
5 Top Inflations Hedges to Know
Depending on your risk tolerance, you probably wouldn’t want to keep all of your wealth in inflation hedges. Although they might be secure, they also tend to earn minimal returns. You’ll unlikely get rich from these assets, but it’s also unlikely you’ll lose money.
Many investors turn to these secure investments when they notice an inflationary environment is gaining momentum. Here’s what you should know about the most common inflation hedges.
1. Gold
Some say gold is over-hyped, because not only does it not pay interest or dividends, but it also does poorly when the economy is doing well. Central banks, who own most of the world’s gold, can also deflate its price by selling some of its stockpile. Gold’s popularity might be partially linked to the “gold standard”, which is the way countries used to value its currency. The U.S. hasn’t used the gold standard since 1933.
Still, gold’s stability in a crisis could be good for investors who need to diversify their assets or for someone who’s very risk-averse.
If you want to buy physical gold, you can get gold bars or coins — but these can be risky to store and cumbersome to sell. It can also be hard to determine their value if they have a commemorative or artistic design or are gold-plated. Another option is to buy gold stocks or mutual funds.
Is gold right for you? You’ll need to determine how much risk you’re willing to tolerate with your investments since gold offers a low risk but also a low reward.
Pros
- Physical asset: Gold is a physical asset in limited supply so it tends to hold its value.
- Low correlation: Creating a diversified portfolio means investing in asset classes that don’t move together. Gold has a relatively low correlation to many popular asset classes, helping you potentially hedge your risk.
- Performs well in recessions: Since many investors see gold as a hedge against uncertainty, it is often in high demand during a recession.
Cons
- No dividends: Gold doesn’t pay any dividends; the only way to make money on gold is to sell it.
- Speculative: Gold creates no value on its own. It’s not a business that builds products or employs workers, thereby growing the economy. Its price is merely driven by supply and demand.
- Not good during low inflation: Since gold doesn’t have a huge upside, during periods of low inflation investors generally prefer taking larger risks and will thereby sell gold, driving down its price.
2. Real Estate Investment Trusts (REITs)
Buying real estate can be messy — it takes a long time, there are many extra fees, and at the end of the process, you have a property you need to manage. Buying REITs, however, is simple.
REITs provide a hedge for investors who need to diversify their portfolio and want to do so by getting into real estate. They’re listed on major stock exchanges and you can buy shares in them like you would any other stock.
If you’re considering a REIT as an inflation hedge you’ll want to start your investment process by researching which REITs you’re interested in. There are REITs in many industries such as health care, mortgage or retail.
Choose an industry that you feel most comfortable with, then assess the specific REITs in that industry. Look at their balance sheets and review how much debt they have. Since REITs must give 90% of their income to shareholders they often use debt to finance their growth. A REIT that carries a lot of debt is a red flag.
Pros
- No corporate tax: No matter how profitable they become, REITs pay zero corporate tax.
- High dividends: REITs must disperse at least 90% of their taxable income to shareholders, most pay out 100%.
- Diversified class: REITs give you a way to invest in real estate and diversify your assets if you’re primarily invested in equities.
Cons
- Sensitive to interest rate: REITs can react strongly to interest rate increases.
- Large tax consequences: The government treats REITs as ordinary income, so you won’t receive the reduced tax rate that the government uses to assess other dividends.
- Based on property values: The value of your shares in a REIT will fall if property values decline.
3. Aggregate Bond Index
A bond is an investment security — basically an agreement that an investor will lend money for a specified time period. You earn a return when the entity to whom you loaned money pays you back, with interest. A bond index fund invests in a portfolio of bonds that hope to perform similarly to an identified index. Bonds are typically considered to be safe investments, but the bond market can be complicated.
If you’re just getting started with investing, or if you don’t have time to research the bond market, an aggregate bond index can be helpful because it has diversification built into its premise.
Of course, with an aggregate bond index you run the risk that the value of your investment will decrease as interest rates increase. This is a common risk if you’re investing in bonds — as the interest rate rises, older issued bonds can’t compete with new bonds that earn a higher return for their investors.
Be sure to weigh the credit risk to see how likely it is that the bond index will be downgraded. You can determine this by reviewing its credit rating.
Pros
- Diversification: You can invest in several bond types with varying durations, all within the same fund.
- Good for passive investment: Bond index funds require less active management to maintain, simplifying the process of investing in bonds.
- Consistency: Bond indexes pay a return that’s consistent with the market. You’re not going to win big, but you probably won’t lose big either.
Cons
- Sensitive to interest rate fluctuations: Bond index funds invested in government securities (a common investment) are particularly sensitive to changes to the federal interest rate.
- Low reward: Bond index funds are typically stable investments, but will likely generate smaller returns over time than a riskier investment.
4. 60/40 Portfolio
Financial advisors used to highly recommend a 60/40 stock-bond mix to create a diversified investment portfolio that hedged against inflation. However, in recent years that advice has come under scrutiny and many leading financial experts no longer recommend this approach.
Instead, investors recommend even more diversification and what’s called an “environmentally balanced” portfolio which offers more consistency and does better in down markets. If you’re considering a 60/40 mix, do your research to compare how this performs against an environmentally balanced approach over time before making your final decision.
Pros
- Simple rule of thumb: Learning how to diversify your portfolio can be hard, the 60/40 method simplifies the process.
- Low risk: The bond portion of the diversified portfolio serves to mitigate the risk and hedge against inflation.
- Low cost: You likely don’t have to pay an advisor to help you build a 60/40 portfolio, which can eliminate some of the cost associated with investing.
Cons
- Not enough diversification: Financial managers are now suggesting even greater diversification with additional asset classes, beyond stocks and bonds.
- Not a high enough return: New monetary policies and the growth of digital technology are just a few of the reasons why the 60/40 mix doesn’t perform in current times the same way it did during the peak of its popularity in the 1980s and 1990s.
5. Treasury inflation-protected securities (TIPS)
Since TIPS are indexed for inflation they’re one of the most reliable ways to guard yourself against high inflation. Also, every six months they pay interest, which could provide you with a small return.
You can buy TIPS from the Treasury Direct system in maturities of five, 10 or 30 years. Keep in mind that there’s always the risk of deflation when it comes to TIPS. You’re always guaranteed a minimum of your original principal at maturity, but inflation could impact your interest earnings.
Pros
- Low risk: Treasury bonds are backed by the federal government.
- Indexed for inflation: TIPS will automatically increase its principle to compensate for inflation. You’ll never receive less than your principal at maturity.
- Interest payments keep pace with inflation: The interest rate is determined based on the inflation-adjusted principal.
Cons
- Low rate of return: The interest rate is typically very low, other secure investments that don’t adjust for inflation could be higher.
- Most desirable in times of high inflation: Since the rate of return for TIPS is so low, the only way to get a lot of value from this investment is to hold it during a time when inflation increases and you need protection. If inflation doesn’t increase, there could be a significant opportunity cost.
The Bottom Line
Inflation represents a real risk for investors as it could erode the principal value of your investment. Make sure your investments are keeping pace with inflation, at a minimum.
Inflation hedges can protect some of your assets from inflation. Although you don’t always have to put your money in inflation hedges, they can be helpful if you notice the market is heading into an inflationary period.
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