2021 saw an inflation rate of 7%, making it the highest rate in decades.
Inflation is a constant factor and affects all investors. It can result in losses for individuals and businesses, and the best way to avoid these losses is to hedge against inflation.
So what does it mean to hedge against inflation? Keep reading to find out.
What Does Inflation Hedge Mean?
Inflation is one of the most important economic forces for investors to understand. It’s the reduction in the value of financial assets along with the returns that those assets produce. While some assets naturally lose value with time, this refers to a loss in terms of purchasing power and relates to all assets.
Investors work to increase their wealth with time, and to do this they need to hedge against inflation. An inflation hedge is an asset that produces returns that match or exceed the inflation rate. This means that with time, the value will either stay the same or increase.
Investors aim to incorporate these kinds of assets into their portfolios while removing any that don’t protect against inflation.
Best Investments to Hedge Against Inflation
Inflation rates change each year, meaning past solutions don’t always work. No assets are guaranteed to hedge against inflation, but some are far more reliable than others.
People often settle on buying gold to protect against inflation. Despite its popularity, there have been some periods where inflation has been very high and it has not quite stood up.
Gold has a correlation of 0.16 to inflation, which isn’t particularly high. It’s worth noting that gold also generates no dividends or interest, which some other assets do. This means that to hedge against inflation its value has to increase at the same rate.
Real estate has long been one of the best assets for hedging against inflation. The value of property tends to increase at a higher rate than inflation does. On top of that, property can generate a lot of income through renting/leasing.
REITs (real estate investment trusts) are companies that own or finance real estate that generates income and covers a range of sectors. Of the different REITs available, equity REITs have the best correlation with inflation. Mortgage REITs are another option, but can sometimes underperform when inflation is high.
Commodities generally perform well against inflation and include a range of assets such as:
- Oil and gas
- Precious metals
- Grains and foods
- Building materials
You can invest in these through stocks, which will increase in value as the commodities do.
ETFs (exchange-traded funds) track price movements of different commodities, generally holding derivatives or futures instead of the actual commodities themselves. These are ideal for investors who don’t want to invest in a commodity directly.
TIPS and Floating Rate Bonds
TIPS (Treasury Inflation-Protected Securities) are government bonds. They are pegged to inflation, meaning they will increase at the same rate. The coupon payment is reset every year to match the CPI (Consumer Price Index).
Other floating rate bonds work similarly but are pegged to interest rates rather than the CPI.
Stocks are another very well-known investment choice. The thing that’s noteworthy with stocks is that they do best when inflation is modest – ideally between 1% and 4%.
When inflation is below 1% most stocks will have negative returns. Above 1% will give positive returns, but when inflation is over 4% it generally exceeds the returns from stocks.
The return rates can vary a lot depending on the type of company a stock is. Companies that deal with sustainable resources tend to have a better correlation with inflation.
Some companies can change their prices without much change in costs, meaning they can adjust to meet inflation. Companies that use many raw materials can’t generally do this as they have much less flexibility.
Value stocks can be a good choice as they don’t tend to be too sensitive to price increases. Dividend stocks are also good as they raise dividends with time.
Worst Investments to Hedge Against Inflation
The above assets are generally good options for hedging against inflation. There are, however, some places you can put your money that aren’t nearly as good.
Most people keep their funds in cash, but it tends to always experience value erosion. Short-term fixed-yield instruments are similar, so not the best choice.
Long-dated US Treasuries and corporate bonds have fixed yields and almost always underperform. Inflation is often higher than the coupon, which will result in a negative inflation-adjusted return.
High-end luxury goods stocks and discretionary goods may seem like a good idea, but when prices rise people tend to opt for cheaper alternatives, which makes these stocks underperform.
What About Crypto?
Bitcoin and other cryptocurrencies are very recent assets, and there is still a lot of debate regarding them. Many people claim they’re an effective hedge against inflation, but due to how new the technology is, there currently isn’t enough data to say for a certainty.
Even with this knowledge about the different options for hedging against inflation, some limitations make it difficult.
Inflation projections aren’t set in stone, so they won’t always be accurate. Even someone with years of experience in investing won’t always make the right purchases.
While it’s fairly clear that some investments are better than others, no assets are perfect for hedging against inflation. You should do as much research as you can into the options you have, and make a choice based on what you think is best.
Be aware that there’s always a risk with any investment. Determine the risk before investing so you know what the losses will be if things don’t go how you want them to.
Making the Right Choices
Making decisions when it comes to investing is never easy. No one ever knows for certain how their investments will pan out, and there’s always a chance of losing money. The best thing you can do to hedge against inflation is to diversify your investment portfolio – that way, if one of your assets doesn’t do well, you have less chance of making significant losses.
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