The Ways to Hedge Against Inflation

Hedging Inflation

The rate at which the value of a currency falls and, as a result, the general level of prices for goods and services rises is referred to as inflation. Inflation is a natural occurrence in any economy, however inflation hedging can be used to counteract the expected loss in the price of a currency, thereby maintaining purchasing power.

Hedging against inflation can also help protect an investment's value. When inflation is taken into account, certain investments that appear to generate a good return can be sold at a loss. During inflationary periods, a conscientious investor can plan for inflation by developing asset classes that outperform the market. Although traditional bonds are the most popular choice for income investors, they aren't the only source of income.

When looking for inflation protection, these are the top five asset groups to consider. They include anything from stocks to bonds to alternative assets. All are viable options for an individual investor, though they come with varying degrees of risk.

1. Invest in stocks instead of bonds.

If inflation rises, it will be a punch in the gut for the bond market, but it could be a boost for the stock market. To take advantage of this likely trend, consider relocating 10% of your portfolio from bonds to equities.

A 60/40 stock/bond portfolio is regarded as a safe and conservative stock/bond mix. The Dimensional DFA Global Allocation 60/40 Portfolio is an example of a stock/bond portfolio.

Another option is to purchase preferred stocks. These liquid securities will provide a greater interest than most forms of bonds, and they may not depreciate as much as bonds when inflation occurs.

Utility stocks are a third option, with a price that rises and falls in a reasonably predictable manner over the economic cycle while also paying consistent dividends.

2. Expand your horizons. Internationally

In the United States, investors choose stocks and bonds, but this strategy can be costly in the long run, especially during inflationary periods. In order to protect against inflation, increasing overseas exposure can be a beneficial strategy.

Italy, Australia, and South Korea, for example, are large economies that do not rise and fall in lockstep with the US market indices. Adding companies from these or similar countries to your portfolio can help you hedge against home economic cycles. Bonds issued by foreign issuers can provide investors with a source of fixed income that is unlikely to fall in value if domestic inflation rises.

ETFs and mutual funds are two of the most straightforward ways to diversify investments into international markets. When compared to acquiring a portfolio of American Depositary Receipts (ADRs) or foreign stocks, these funds are a low-cost method to invest. If you're already invested in S&P 500 index funds, you might want to diversify your holdings with an international index fund.

3. Take into account real estate

Investing in real estate has numerous perks. This asset type has inherent value and pays out dividends on a regular basis. It's a strong inflation hedge because, regardless of the economy, there will always be a demand for homes, and when inflation grows, so do property values, and hence the amount a landlord can charge for rent.

Real estate, on the other hand, is illiquid because it is a tangible asset. Real estate investment trusts (REITs) are another option to examine. REITs are more liquid investments that can be bought and sold easily in the markets. REITs are real estate investment trusts that hold and manage commercial, residential, and industrial properties. Rents and leases provide income, and they often offer higher returns than bonds. Another significant benefit is that their prices will likely be unaffected when interest rates begin to climb because their operating costs will stay essentially stable. The Vanguard Real Estate ETF is an example of a REIT with broad real estate exposure and a low expense ratio.

4. Pay attention to TIPS

Treasury inflation-protected securities (TIPS) are a form of US Treasury bond that is meant to rise in value in tandem with inflation. They're regarded one of the safest investments in the world because they're backed by the United States government.

The bonds are linked to the Consumer Price Index, and their principal amount is reset as the index changes. TIPS pay a fixed rate of interest twice a year, which is applied to the adjusted principal. When there is inflation, the primary grows, and when there is deflation, it declines. TIPS are available in three maturities: five, ten, and thirty years.

Is Gold a Good Inflation Hedging Investment?

One of gold's main selling advantages has always been its ability to protect against inflation. In contrast to paper currencies like the dollar, which lose purchasing power when inflation is high, gold tends to keep its value for the most part.

Gold usually appreciates when inflation rises. Gold, on the other hand, isn't a great inflation hedge. Other factors can influence its prices, which can change dramatically from year to year—and thus its inflation-adjusted returns. In fact, the fluctuation in gold's nominal and real returns during the recent 1-, 5-, 10-, 15-, and 20-year investment horizons has not been driven by realised inflation.

Is Bitcoin a Good Inflation Hedging Tool?

Bitcoin, in theory, may be a good inflation hedge. Assets that investors flock to in times of rising prices, such as precious metals and real estate, are scarce and move in the opposite direction of paper money and financial assets. Bitcoin is a good fit.

The difficulty is that bitcoin hasn't had much of an investment history: it was created in 2009 and has only been regularly traded for a decade or so, during which time inflation hasn't played a significant role.

As a result, no one knows how inflation will effect bitcoin's notoriously unpredictable behaviour. In terms of inflation, its recent performance has been perplexing. As inflation began to rise, Bitcoin doubled in value from mid-December 2020 to early January 2021. But, with no signs of alleviating inflationary pressures, it lost 25% of its value between Jan. 8 and Jan.11 

In May 2021, the debate over inflation became more heated: Stocks shuddered as the Federal Reserve announced a shift away from easy-money policies and a hike in interest rates, but bitcoin plummeted. It ended a month-long drop on May 19 by closing at $38,390, down 41% from its top of $64,829 in mid-April.

Is Real Estate a Good Inflation Hedging Strategy?

Real estate is a tried-and-true inflation hedge. It's a tangible asset, which, unlike paper assets, tends to keep its value when inflation is high. More specifically, as prices grow, property values rise, and the amount a landlord may charge for rent rises, resulting in a bigger rental revenue for the property over time.

There's also the phenomena of "depreciating debt," which refers to the fact that the cost of a real estate owner's mortgage payments actually decreases with time. During example, suppose your monthly mortgage payments total $8,333 for the first year of your loan. They'll stay the same nominally—$100,000 per year—but if inflation continues, they'll be worth only $80,000 in ten years.