Protecting Your Investment Portfolio from Inflation
From gas to groceries, prices have risen across the board over the last year with inflation reaching 8.6% in June 2022. But inflation not only makes things more expensive, it can also have a negative impact on your investment portfolio.
Aside from household goods and services, inflation affects stock prices, bond rates, and potential returns on equity. At the same time, it reduces your purchasing power, which means each dollar in your account is worth less and won’t stretch as far.
The good news is that there are ways to protect your investment portfolio from the forces of inflation. Here’s how savvy investors outpace inflation to ensure that their hard-earned savings continue to meet their needs for years into the future.
What is Inflation?
Inflation refers to a general increase in the price of goods and services in the economy, measured by the Consumer Price Index (CPI). As the overall price level increases, the purchasing power of each unit of currency decrease. In other words, as inflation occurs, consumers can purchase fewer goods and services for the same dollar amount.
The Federal Reserve and all central banks prefer to keep inflation modest, generally aiming for an annual inflation rate of 2% to maintain steady economic growth. If there is zero or negative inflation, that is referred to as deflation and can be destabilizing to local and global economies. Another concern for financial experts during times of high inflation is if that rise in price level is not matched by economic growth, that is referred to as stagflation.
Inflation above 3% annually indicates a period of high inflation, but should not be a concern right away. The issue of high inflation arises when there is consistent rapid growth in the rate of inflation that is not matched by a rise in average income. If inflation is not controlled, it can lead to an economic recession.
How Does Inflation Impact Your Investments?
Investment assets with fixed, long-term cash flows tend to underperform when inflation is rising as the purchasing power of those future cash flows will decline over time. On the other hand, assets with adjustable cash flows such as rental properties along with other alternative investments such as commodities tend to perform better with rising inflation.
Inflation has the largest impact on cash such as a savings account and inflation directly reduces your buying power. Outside of cash, rising inflation negatively impacts the value of bonds and many equities.
Fixed income securities are often purchased in order to receive a stable income stream from interest payments. When purchasing power falls, the actual value of interest payments declines as well. As a result, bond prices historically have fallen when inflation in rising. Accelerating inflation is most detrimental to longer-term bonds given the cumulative impact of decreasing purchasing power for future cash flows.
The stock market’s response to inflation is slightly more complex. In theory, a company’s revenue and earnings should be able to keep pace with inflation, meaning the price of a share should climb alongside the general price level. Companies that are able to pass inflation costs onto consumers will typically outperform in times of high inflation, while some industries will suffer if consumer spending decreases in response to higher prices.
Over time, inflation can have a significant impact on your investment portfolio. In order to protect future returns from eroding purchasing power, consider diversifying your portfolio to assets that are either protected against inflation or even have a positive relationship with rising inflation.
Alternative Investments as Inflation Hedges
Alternative investments differ from traditional investment vehicles because they have a low correlation with the movements of the traditional stock market. Alternative returns also do not rely on current cash flows, so a decrease in purchasing power does not impact any short-term financial returns.
Real estate is considered a standard approach to hedge against inflation given its low correlation with stocks and bonds. Some of the most common investment options in this sector include:
- Direct ownership (buying and renting out property to tenants)
- Indirect ownership through a real estate investment trust (REIT)
- Indirect ownership through a real estate investment group (REIG)
Income-producing real estate properties perform well with inflation because property values rise alongside inflation and landlords are able to pass through the impacts of inflation onto the buyer.
Real estate investment trusts (REITs) – a pool of real estate that pays out dividends to investors – are also strong hedges against inflation for the same reason. REITs also allow for retail investors to access the diversification provided by real estate assets without the start up cost of purchasing a property.
Commodities refer to a wide array of investments including gold, precious metals, oil, livestock, natural gas, and more. Gold has long been considered the standard hedge against inflation. Investors have historically rushed to transfer traditional assets into gold when they worry a recession is coming.
Metals are tangible, scarce, and have historically shown to have a negative correlation to paper money. During periods of higher inflation, gold tends to hold or gain value better than other investments.
Aside from owning physical gold, consider accessing gold and other precious metal investments through an exchange-traded fund (ETF). Gold ETFs trade like any other stock, and you can invest using an online brokerage.
As the alternative investment market has broadened over time, gold is no longer a true pure inflation hedge. Typically, as inflation rises, central banks will increase interest rates as a monetary policy strategy to help keep inflation at bay. Because real assets such as gold pay no yield, that rise in interest rates is not seen in the value of the commodity.
Blue-chip art is seen as an inflation hedge because of its low volatility, low correlation with the stock market, and its ability to retain value as a real asset. In a worst-case scenario of high inflation causing a slowdown in consumer spending that affects stock market returns, real assets such as fine art historically retain their value.
The long-term nature of art as an investment also helps retain value as it does not generate cash flows subject to purchasing power declines. Similar to real estate or commodities, blue-chip art can either be purchased on its own or fractionally.
Treasury Inflation-Protected Securities (TIPS)
One of the most straightforward ways to inflation-proof your investment portfolio is to choose investments that are designed to protect against it. Treasury Inflation-Protected Securities (TIPs) are treasury bonds that are specifically designed to help investors storm the rising and falling inflation throughout the years.
TIPs principal is tied to changes in the Consumer Price Index (CPI), which analyzes and measures inflation. Inflation (increase in the CPI) causes TIPs’ principal to increase. It decreases with deflation (decline in the CPI).
TIPs pay a fixed rate of interest twice a year, with the amount based on the adjusted value of the principal.
Because TIPs are government-backed bonds, they’re one of the safest ways to prevent inflation from adversely impacting your portfolio. Whether inflation goes up or down, your risk of losing money is much lower.
While there are plenty of valid reasons to be concerned about during periods of inflation, there are several ways to harden your investment portfolio against inflation. Instead of letting fear take over, make the situation work for you. From TIPs to alternative investments, knowing how to protect your portfolio, especially during volatile times, will give you peace of mind and confidence. Make the right moves and you too can weather the storm.