A dollar today will not buy the same value of goods in ten years. This is due to inflation. Inflation measures the average price level of a basket of goods and services in an economy; it refers to the increases in prices over a specified period of time. As a result of inflation, a specific amount of currency will be able to buy less than before. Therefore, it is important to find the right strategies and investments to hedge against inflation.
The level of inflation in an economy changes depending on current events. Rising wages and rapid increases in raw materials, such as oil, are two factors that contribute to inflation.
Inflation is a natural occurrence in the market economy. There are many ways to hedge against inflation; a disciplined investor can plan for inflation by investing in asset classes that outperform the market during inflationary climates.
Keeping inflation-hedged asset classes on your watch list—and then striking when you see inflation begin to take shape in a real, organic growth economy—can help your portfolio thrive when inflation hits.
Key Takeaways
- Inflation occurs in market economies, but investors can plan for inflation by investing in asset classes that tend to outperform the market during inflationary climates.
- With any diversified portfolio, keeping inflation-hedged asset classes on your watch list, and then striking when you see inflation can help your portfolio thrive when inflation hits.
- Common anti-inflation assets include gold, commodities, various real estate investments, and TIPS.
- Many people have looked to gold as an “alternative currency,” particularly in countries where the native currency is losing value.
- Commodities and inflation have a unique relationship, where commodities are an indicator of inflation to come; as the price of a commodity rises, so does the price of the products that the commodity is used to produce.
Here are some of the top ways to hedge against inflation:
1. Gold
Gold has often been considered a hedge against inflation. In fact, many people have looked to gold as an “alternative currency,” particularly in countries where the native currency is losing value. These countries tend to utilize gold or other strong currencies when their own currency has failed. Gold is a real, physical asset, and tends to hold its value for the most part.
Inflation is caused by a rise in the price of goods or services. A rise in the price of goods or services is driven by supply and demand. A rise in demand can push prices higher, while a supply reduction can also drive prices. Demand can also rise because consumers have more money to spend.
However, gold is not a true perfect hedge against inflation. When inflation rises, central banks tend to increase interest rates as part of monetary policy. Holding onto an asset like gold that pays no yields is not as valuable as holding onto an asset that does, particularly when rates are higher, meaning yields are higher.
There are better assets to invest in when aiming to protect yourself against inflation. But like any strong portfolio, diversification is key, and if you are considering investing in gold, the SPDR Gold Shares ETF (GLD) is a worthwhile consideration.
2. Commodities
Commodities are a broad category that includes grain, precious metals, electricity, oil, beef, orange juice, and natural gas, as well as foreign currencies, emissions, and certain other financial instruments. Commodities and inflation have a unique relationship, where commodities are an indicator of inflation to come. As the price of a commodity rises, so does the price of the products that the commodity is used to produce.
Fortunately, it’s possible to broadly invest in commodities via exchange-traded funds (ETFs). The iShares S&P GSCI Commodity-Indexed Trust (GSG) is a commodity ETF worth considering.
Before investing in commodities, investors should be aware that they are highly volatile and investor caution is advised in commodity trading. Because commodities are dependent on demand and supply factors, a slight change in supply due to geopolitical tensions or conflicts can adversely affect the prices of commodities.
3. 60/40 Stock/Bond Portfolio
A 60/40 stock/bond portfolio is considered to be a safe, traditional mix of stocks and bonds in a conservative portfolio. If you don’t want to do the work on your own and you’re reluctant to pay an investment advisor to assemble such a portfolio, consider investing in Dimensional DFA Global Allocation 60/40 Portfolio (I) (DGSIX).
A 60/40 stock/bond portfolio is a straightforward, easy investment strategy. But like all investment plans, it does have some disadvantages. Compared to an all-equity portfolio, a 60/40 portfolio will underperform over the long term. Additionally, over very long time periods, a 60/40 portfolio may significantly underperform an all-equity portfolio because of the effects of compounding interest.
It’s important to keep in mind that a 60/40 portfolio will help you hedge against inflation (and keep you safer), but you’ll likely be missing out on returns compared to a portfolio with a higher percentage of stocks.
4. Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) are companies that own and operate income-producing real estate. Property prices and rental income tend to rise when inflation rises. An REIT consists of a pool of real estate that pays out dividends to its investors. If you seek broad exposure to real estate to go along with a low expense ratio, consider the Vanguard Real Estate ETF (VNQ).
REITs also have some drawbacks, including their sensitivity to demand other high-yield assets. When interest rates rise, Treasury securities generally become attractive. This can draw funds away from REITs and lower their share prices.
REITs must also pay property taxes, which can make up as much as 25% of total operating expenses. If state or municipal authorities decided to increase property taxes to make up for their budget shortfalls, this would significantly reduce cash flows to shareholders. Finally, while REITs offer high yields, taxes are due on the dividends. The tax rates are typically higher than the 15% most dividends are currently taxed at because a high percentage of REIT dividends are considered ordinary income, which is usually taxed at a higher rate.
5. S&P 500
Stocks offer the most upside potential in the long term. In general, businesses that gain from inflation are those that require little capital (whereas businesses that are engaged in natural resources are inflation losers).
Currently, the S&P 500 has a high concentration of technology businesses and communication services. (They account for a 35% stake in the Index.) Both technology and communication services are capital-light businesses, so, theoretically, they should be inflation winners.
If you wish to invest in the S&P 500, an index of the 500 largest U.S. public companies—or if you favor an ETF that tracks it for your watch list—look into the SPDR S&P 500 ETF (SPY).
However, like any investment, there are disadvantages to investing in the S&P 500 Index. The main drawback is that the Index gives higher weights to companies with more market capitalization, so the stock prices for the largest companies have a much greater influence on the Index than a company with a lower market cap. And the S&P 500 index does not provide any exposure to small-cap companies, which historically produced higher returns.
6. Real Estate Income
Real estate income is income earned from renting out a property. Real estate works well with inflation. This is because, as inflation rises, so do property values, and so does the amount a landlord can charge for rent. This results in the landlord earning a higher rental income over time. This helps to keep pace with the rise in inflation. For this reason, real estate income is one of the best ways to hedge an investment portfolio against inflation.
For future exposure, consider VanEck Vectors Mortgage REIT Income ETF (MORT).
Like any investment, there are pros and cons to investing in real estate. First, when purchasing real estate, the transaction costs are considerably higher (as compared to purchasing shares of a stock). Second, real estate investments are illiquid, meaning they can’t be quickly and easily sold without a substantial loss in value. If you are purchasing a property, it requires management and maintenance, and these costs can add up quickly. And finally, real estate investing involves taking on a great deal of financial and legal liability.
7. Bloomberg Barclays Aggregate Bond Index
The Bloomberg Barclays Aggregate Bond Index is a market index that measures the U.S. bond market. All bonds are covered in the index: government, corporate, taxable, and municipal bonds. To invest in this index, investors can invest in funds that aim to replicate the performance of the index. There are many funds that track this index, one of them being the iShares Core U.S. Aggregate Bond ETF (AGG).
There are some disadvantages to investing in the Bloomberg Barclays U.S. Aggregate Bond Index as a core fixed-income allocation.
First, it is weighted toward the companies and agencies that have the most debt. Unlike the S&P 500 Index, which is market-capitalization-weighted—the bigger the company, the bigger its position in the index—the largest components of the Bloomberg Barclays U.S. Aggregate Bond Index are the companies and agencies with the most debt outstanding. In addition, it is heavily weighted toward U.S. government exposure, so it is not necessarily well-diversified across sectors of the bond market.
8. Leveraged Loans
A leveraged loan is a loan that is made to companies that already have high levels of debt or a low credit score. These loans have higher risks of default and therefore are more expensive to the borrower.
Leveraged loans as an asset class are typically referred to as collateralized loan obligations (CLOs). These are multiple loans that have been pooled into one security. The investor receives scheduled debt payments from the underlying loans. CLOs typically have a floating rate yield, which makes them a good hedge against inflation. If you’re interested in this approach at some point down the road, consider Invesco Senior Loan ETF (BKLN).
Like every investment, leveraged loans involve a trade-off between rewards and risks. Some of the risks of investing in funds that invest in leveraged loans are credit default, liquidity, and fewer protections.
Borrowers of leveraged loans can shutter their business or reach a point where they are unable to pay their debts. Leveraged loans may not be as easily purchased or sold as publicly traded securities. And finally, leveraged loans generally have fewer restrictions in place to protect the lender than traditional loans. This could leave a fund exposed to greater losses if the borrower is unable to pay back the loan.
9. TIPS
Treasury inflation-protected securities (TIPS), a type of U.S. Treasury bond, are indexed to inflation in order to explicitly protect investors from inflation. Twice a year, TIPS payout at a fixed rate. The principal value of TIPS changes based on the inflation rate, therefore, the rate of return includes the adjusted principal. TIPS come in three maturities: five-year, 10-year, and 30-year.
If you favor using an ETF as your vehicle, the three choices below might appeal to you.
The iShares TIPS Bond ETF (TIP)
The Schwab US TIPS ETF (SCHP)
The FlexShares iBoxx 3-Year Target Duration TIPS Index ETF (TDTT)
Even though TIPS may appear like an attractive investment, there are a few risks that are important for investors to keep in mind. If there is deflation or the Consumer Price Index (CPI) is falling, the principal amount may drop. If there is an increase in the face value of the bond, you will also have to pay more tax (and this could nullify any benefit you may receive from investing in TIPS). Finally, TIPS are sensitive to any change in the current interest rates, so if you sell your investment before maturity, you may lose some money.
Does Whole Life Insurance Hedge Against Inflation?
Whole life insurance is a contract designed to provide protection over the insured’s entire lifetime. Because whole life insurance is a long-term purchase, the guaranteed return on this type of policy provides little inflation protection. However, it is sometimes referred to as a hedge against inflation because the dividends paid on participating policies—which reflect the favorable mortality, investment, and business expense results of the insurer—can act as a partial hedge against inflation.
Are CDs a Good Hedge Against Inflation?
A certificate of deposit (CD) is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. Typical CDs are not protected against inflation. If you would like to reduce the impacts of inflation on your CD investments, consider buying a CD that is higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be.
Are Annuities a Good Hedge Against Inflation?
Annuities are not often considered a good hedge against inflation; in fact, the primary risk of most annuity payouts is inflation. This is because commercial annuities generally pay a fixed monthly income, rather than an inflation-adjusted income. If your annuity pays a fixed $3,000 per month for life, and inflation increases 12%, the buying power of your annuity payments decreases to $2,640. Variable annuities that adjust with interest rates may offer better inflation protection than fixed annuities.
What Is Inflation Protection Home Insurance?
Some insurance policies have a feature called insurance inflation protection, which stipulates that future or ongoing benefits to be paid are adjusted upward with inflation. Inflation protection home insurance is intended to ensure that the relative buying power of the dollars granted as benefits does not erode over time due to inflation.