One of the first truths you learn is that everything is an investment, even holding cash in a savings account. But unlike other investments that provide price appreciation, interest, or dividend payments, cash doesn’t produce any returns.
Instead, cash loses purchasing power relative to the rising cost of goods over time. The loss of purchasing power is the result of inflation. Over time, prices rise. That’s why your grandparents could walk into a candy shop with a quarter and come out smiling ear to ear, but today a quarter won’t buy you anything.
But how do investors protect themselves from inflation?
What Is an Inflation Hedge?
An inflation hedge is an investment that’s made to protect investors from a decrease in purchasing power as a result of rising consumer prices in an inflationary environment.
These investments are made in assets that are known for a strong correlation with measures of consumer prices, like the Consumer Price Index (CPI).
How Inflation Hedges Work
To understand how inflation hedges work, it’s important to understand the basics of inflation itself. Over time, demand for products and services will rise and fall. Supplies of these products and services will have their own trends.
When demand outweighs supply overall, prices tend to rise, leading to an inflationary environment.
The best real-world example of this is gasoline. According to the EIA, gas prices were nearing $3 on average across the United States before the COVID-19 pandemic. When the pandemic set in, travel dropped off, and gas fell to low averages of around $1.80 per gallon.
As it began to become safe to leave home again and Federal stimulus reached consumers, demand for gasoline increased. Then Russia’s invasion of Ukraine impacted the global supply of crude oil (needed to make gasoline), restricting supply.
With demand higher than supply, the national average price for a gallon of gas shot up to more than $4 per gallon. A single dollar bill out of your pocket during the depths of the COVID-19 pandemic would have purchased more than twice as much gas as it will today.
High inflation leads to a reduction of purchasing power.
Investors using inflation hedges with an “if you can’t beat ‘em, join ‘em” approach. By investing in commodities, real estate, and other assets that are known to perform well when inflation rises, these investors ride the inflation train to the top.
Types of Inflation Hedges
Diversification is important when investing in inflation hedges. Most well-diversified portfolios have an allocation to a range of hedges across various different asset classes. Mix in at least three or four different hedges to ensure you’re covered if prices start to rise and one doesn’t perform as well as you thought.
Some of the most common types of inflation hedges include:
Treasury Inflation-Protected Securities (TIPS)
Treasury inflation-protected securities (TIPS) are some of the most popular inflation hedges on the market today. TIPS are debt securities issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government, making them a great source of volatility protection. They’re also a compelling option for investors looking to protect the value of their money.
Like other bonds, these fixed-income securities offer a coupon rate. However, unlike traditional bonds, the coupon payments that come from this unique government bond are variable, tied to a benchmark that’s designed to track the inflation rate.
When higher inflation levels take place, the coupon rate of these bonds will adjust to maintain purchasing power. However, in times of deflation, when consumer prices fall, the returns from TIPS will be reduced.
The reimbursement of capital the investor receives at the maturity of these bonds is also heavily dependent on inflation. When TIPS reach maturity, the original face value of the bond is adjusted based on inflation over the life of the security. If the prices climbed over that time period, the face value will be adjusted upward, and if prices fell, the value will be adjusted downward before being returned to the investor.
Floating-rate notes, also known as floating-rate bonds, are a type of bond that’s tied to an underlying benchmark, benefiting investors as economic conditions change in an inflationary environment, much like TIPS. However, there are two major differences between the two:
- The Issuer. The issuer of TIPS is always the U.S. Treasury. Floating-rate notes can be issued by financial institutions, governments, or corporations and may come with higher credit risk than TIPS.
- The Benchmark. TIPS are tied to inflation-centric benchmarks like the CPI, whereas floating-rate notes are tied to interest rate-related benchmarks like the fed funds rate set by the Federal Reserve.
So, what makes floating-rate notes a good inflation hedge?
The Federal Reserve and other central banks around the world pay close attention to consumer prices. When the rate of inflation climbs to unsustainable levels, central banks enact monetary policy to attempt to slow increasing prices. These banks have several policy options, but one of the first big changes they generally make to combat inflation is to increase interest rates.
Borrowers are less likely to borrow money when interest rates are high, squeezing the economy of excess funds. With less money rolling around, demand stalls, resulting in a slowed rate of inflation.
Investors who purchase floating-rate notes welcome inflation because it’s a sign that interest rates are likely to rise. As interest rates rise, the bond’s coupon payments and face value follow suit, resulting in a larger return for the investor that offsets the reduction in the value of money itself.
Inflation-Protected Annuities (IPAs)
Annuities are a staple in income investing. Like bonds, they provide investors with a fixed income over a potentially long period of time. Unlike bonds, the face value of an annuity is gradually paid out over time through regular interest payments, rather than coupon payments being made and the face value being paid out at maturity.
Inflation-protected annuities work just like traditional annuities with one major difference. These annuities guarantee real returns that are at or above the rate of inflation.
IPAs are linked to an inflation index like the CPI. Annuity payments are adjusted for inflation based on the reading of the underlying index, meaning that payments grow when inflation rates are high and shrink if deflation sets in.
Real estate is a staple in various moguls’ investment portfolios. Why do so many high net worth individuals keep so much of their wealth invested in real property?
Because real estate is a great inflation hedge.
Prices rise due to increased demand, which is generally the result of positive economic conditions. Consumers are far more likely to purchase a house when economic conditions are positive than when economic concerns lead to job insecurity.
As a result, real estate prices tend to balloon when inflation levels are high.
Of course, anyone who owns real estate in these markets stands to make a significant amount of money. Investors can sell their real property at inflation-driven highs or rent it out, earning a residual income that tends to rise from year to year, offsetting the effects of inflation.
Unfortunately, it costs quite a bit of money to buy a piece of property. The good news is that if you’re interested in real estate investing, there’s an inexpensive way to tap into the market.
Real estate investment trusts, also known as REITs, are a type of bucket investment. The REIT manager accepts money from a pool of investors to cover the cost of property acquisitions and maintenance. The properties owned by the REIT are then put on the market for rent.
When the REIT collects rent, its excess earnings above and beyond the cost of maintenance and retained earnings for future acquisitions are paid out to its shareholders in the form of dividends.
Stocks have long been viewed as one of the best hedges against inflation in the long term. Sure, when inflation levels are exorbitantly high, stock prices tend to fall back because fears of interest rate hikes and reduced consumer demand hurt the market.
Although the ride through an inflationary period may be bumpy for stocks, it often maintains an upward trajectory.
Over the long term, the stock market has outpaced inflation significantly. The key to visualizing that is to zoom out far enough to weed out the noise of short-term volatility. Stocks grow at a rate of around 10% per year when averaged over a long period of time. According to YCharts, the long-term rate of inflation is just over 3%.
The keys are taking the time to do adequate research, patience to ride out short-term volatility, and maintaining a well-diversified portfolio.
Exchange-Traded Funds (ETFs) & Mutual Funds
If you don’t have the time or expertise to build a well-diversified portfolio of stocks, but you want to tap into the purchase power protection of the stock market, ETFs and mutual funds are great options to consider.
Like REITs, these funds pool money from a large group of investors, using the consolidated funds to build a diversified portfolio of investments. However, unlike REITs, these investments are in equities rather than real estate.
As groups of stocks, ETFs provide the same type of inflation hedge you’d get if you invested in a well-diversified portfolio of individual stocks. Historically, stocks have grown at a much faster rate than consumer prices.
Moreover, you can expand the effectiveness of this hedge by focusing on ETFs that are commodity or mining-centric. In doing so, you’ll not only get the inflation hedge provided by a portfolio of stocks, you’ll benefit from increased profitability among the mining and commodities holdings as prices rise.
Precious metals like gold, silver, and palladium have long been viewed as safe-haven investments. These investments are known for a lack of volatility, protecting investors from the ebbs and flows of the equities market. They also act as an effective inflation hedge.
The prices of gold, silver, and other precious metals tend to rise along with consumer prices. So, you’ll be able to sell your holdings in these investments for higher prices when inflation is high. In fact, gold has long been considered one of the best inflation hedges on the market.
Commodities are the basic building blocks of consumer goods. These assets are the wheat in bread, iron ore used to construct high-rise buildings, and the crude oil used to make synthetic rubber in your tires.
When consumer prices climb, so too do the prices of the building blocks that make consumer products possible.
Here’s the trickle effect behind how commodities act as an inflation hedge. Think of tires. When demand for tires increases, more tires must be produced. More oil is needed to produce more of the synthetic rubber used in tires, leading to an increase in oil demand.
When oil demand climbs, it becomes more expensive to make synthetic rubber, and ultimately, the tires. This inflates the price of tires.
So, investors can hedge against a loss of value in their money by purchasing commodities, the building blocks of the developed world as we know it. When inflation runs hot and prices rise, the prices of commodities often increase as well.
Inflation is a major force in financial markets. In times of high inflation, some investments that yield what appear to be gains may actually lose value in terms of purchasing power. Assets that help to protect against these losses are a crucial part of any well-diversified investment portfolio.
However, like any other investment, inflation hedges aren’t created equally. Investors should take the time to do their research and develop a keen understanding of what they’re investing in before they invest.