5 Tips to Hedge Against Inflation
Inflation refers to the ever-increasing price of goods and services as measured against a particular currency. The purchasing power of a currency depreciates as a result of rising prices. Put differently, a rising rate of inflation equates to a decreasing value of a currency.
To achieve financial freedom and build wealth over long periods of time, it’s vital to understand the concept of inflation, and some strategies to protect or hedge against it.
Key Points
• Inflation decreases currency value, impacting savers negatively.
• Moderate inflation encourages spending, benefiting economic growth.
• ETFs offer diversified investment, potentially hedging against inflation.
• Gold has historically maintained purchasing power, serving as a long-term inflation hedge.
• Gold prices can rise sharply during periods of rapid inflation, though this is never assured.
What Is Inflation, and How Is It Measured?
Inflation is most commonly measured by the Consumer Price Index (CPI), which averages the national cost of many consumer items such as food, housing, healthcare, and more.
The opposite of inflation is deflation, which happens when prices fall. During deflation, cash becomes the most valuable asset because it can buy more. During inflation, other assets become more valuable than cash because it takes more currency to purchase them.
As for which assets tend to perform best during times of inflation? This is a much-debated topic among investment analysts and economists, with many differing opinions. And while there may be no single answer to that question, there are still some generally agreed-upon concepts that can help to inform investors on the subject.
Is Inflation Good or Bad for Investors?
For the average person who tries to save money without investing much, inflation could generally be seen as negative. A decline in the purchasing power of the saver’s currency leads to them being less able to afford things, ultimately resulting in a lower standard of living.
For wealthier investors who hold a lot of financial assets, however, inflation might be perceived in a more positive light. As the prices of goods and services rise, so do financial assets. This leads to increasing wealth for some investors. And because currencies always depreciate over the long-term, those who hold a diversified basket of financial assets for long periods of time tend to realize significant returns.
It’s generally thought that there is a certain level of inflation that contributes to a healthier economy by encouraging spending without damaging the purchasing power of the consumer. The idea is that when there is just enough inflation, people will be more likely to spend some of their money sooner, before it depreciates, leading to an increase in economic growth.
When there is too much inflation, however, people can wind up spending most of their income on necessities like food and rent, and there won’t be much discretionary income to spend on other things, which could restrict economic growth.
Central banks like the Federal Reserve try to control inflation through monetary policy. Sometimes their policies can create inflation in financial assets, like quantitative easing has been said to do.
5 Tips for Hedging Against Inflation
There are a number of different strategies investors use to hedge against inflation. The common denominators tend to be hard assets with a limited supply and financial assets that tend to see large capital inflows during times of currency devaluation and rising prices.
Here are five tips that may help investors hedge against inflation.
1. Consider Investing in Real Estate Investment Trusts (REITs)
A Real Estate Investment Trust (REIT) is a company that deals in real estate, either through owning, financing, or operating a group of properties. Through buying shares of a REIT, investors can gain exposure to the assets that the company owns or manages.
REITs are income-producing assets, like dividend-yielding stocks. They pay a dividend to investors who hold shares. In fact, REITs are required by law to distribute 90% of their income to investors.
Holding REITs in a portfolio might make sense for some investors as a potential inflation hedge because they are tied to a hard asset—real estate. During times of high inflation, hard assets tend to rise in value against their local currencies because their supply is limited. There will be an ever-increasing number of dollars (or euros, or yen, etc.) chasing a fixed number of hard assets, so the price of those things will tend to go up.
Owning physical real estate — like a home, commercial complex, or rental property — also works as an inflation hedge. But most investors can’t afford to purchase or don’t care to manage such properties. Holding shares of a REIT provides a much easier way to get exposure to real estate.
2. Know How Bonds and Equities Could React to Inflation
The recurring theme regarding inflation hedges is that the price of everything goes up. What investors are generally concerned with is choosing the assets that go up in price the fastest, with the greatest possible return.
In some cases, it might be that stocks and bonds very quickly rise very high in price. But in an economy that sees hyperinflation, those holding cash won’t see their investment, i.e., cash, have the purchasing power it may have once had.
In such a scenario, the specific securities aren’t as important as making sure that capital gets allocated to stocks or bonds in some amount, instead of holding all capital in cash.
3. Consider Investing in Certain Exchange-Traded Funds
An exchange-traded fund (ETF) that tracks a particular stock index or group of investment types is another way to get exposure to assets that are likely to increase in value during times of inflation and can also be a strategy to maximize diversification in an investor’s portfolio.
ETFs are generally passive investments, which may make them a good fit for those who are new to investing or want to take a more hands-off approach to investing. Since they are considered a diversified investment, they may be a good hedge against inflation.
4. Consider Gold and Gold Mining Stocks
For thousands of years, humans have used gold as a store of value. Although the price of gold or other precious metals can be somewhat volatile in the short term, few assets have maintained their purchasing power as well as gold in the long term. Like real estate, gold is a hard asset with limited supply.
Still, the question of “is gold a hedge against inflation?” has different answers depending on whom you ask. Some critics claim that because there are other variables involved and the price of gold doesn’t always track inflation exactly, that it is not a good inflation hedge. And there might be some circumstances under which this holds true.
Investors seeking to add gold to their portfolio have a variety of options. Physical gold coins and bars might be the most obvious example, although these are difficult to obtain and store safely. But investors can also invest in mining companies, or others that have exposure to the gold market.
5. Do Your Homework About Inflation and the Market
Ultimately, no assets are 100% protected from inflation, but some investments might be better than others for some investors. Understanding how inflation affects investments is the beginning of growing wealth over time and achieving financial goals.
The Takeaway
Inflation is marked by a period of rising prices, and is a normal side effect of a healthy economy — within certain bounds. Inflation may have positive effects for certain people, and bad ones for others, but overall, inflation is generally a negative for savers and consumers. Still, there may be certain investment strategies that can help hedge against inflation.
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FAQ
What is inflation?
Inflation refers to the tendency of prices to rise over time, and is often measured by the Consumer Price Index, or CPI.
Is inflation good for investors?
While inflation is generally a bad thing for consumers and savers, it’s debatable as to whether it’s a positive thing for investors. It largely depends on the specific assets the investor holds.
What assets do some investors invest in during times of inflation?
Some investors may invest in precious metals like gold, real estate through vehicles like REITs, or various stock or bond-related instruments. But it’s important to remember that no asset is likely to be immune to inflation.
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