Investors worry about inflation because it eats away at the purchasing power of their
money and makes their investments have to work harder to produce returns beyond inflation,
or real returns.
For most of the twenty-teens, inflation averaged less than 2%.
But inflation only rose 1.4% year over year in 2020, in large part due to the pandemic.
In April 2021, that rate jumped to about 4.2%, mainly due to multiple rounds of stimulus
and a rapidly reopening economy.
That may not sound high, especially when you look at the high inflation periods like the
70s, when inflation averaged more than 7%, but too much inflation too quickly, called
hyperinflation, can lead to economic instability and market crashes.
While many economists and policy makers don’t think a return to the hyperinflation of the
1970s is likely they see this more as a temporary bump inflation may still pose
slightly higher risks into the 2020s.
When it comes to protecting your portfolio, it can be helpful to see which types of investments
have historically weathered high inflation environments better than others.
Remember, past performance is not a guarantee of future performance.
Look at these charts.
They compare the returns of bonds, stocks, and real estate investment trusts, also known
as REITs.
On the left, you see the overall historical returns from 1972 to 2020.
On the right, you see returns during a period of particularly high inflation, 1974 to 1980.
Over the long term, each investment outperformed inflation, but bonds weren’t able to keep
up during periods of high inflation.
Stocks and REITs, on the other hand, have historically held up better.
But that doesn’t necessarily mean investors should leave bonds out of their portfolios.
Bonds haven’t outperformed high inflation because they typically offer lower returns,
but they have historically grown even when the stock market contracts.
Just look at the Great Recession.
Investors anticipating higher inflation might consider optimizing their bond holdings.
For example, shorter-term rather than longer-term Treasuries can allow you to roll into higher-yielding
Treasuries if interest rates rise in response to higher inflation.
But remember, bonds typically decline in price when interest rates rise and vice versa.
Investing in Treasury Inflation-Protected Securities, also called TIPS, is another possibility.
TIPS are a special type of Treasury indexed to the Consumer Price Index or CPI.
The interest rate earned with a TIPS investment holds steady over its life, but the par value
of the treasury rises with inflation.
But if interest rates rise in a low- or no-inflation environment, the TIPS’ price could decline.
When TIPS mature, the investor is paid the original or adjusted principal, whichever
is greater.
Like we said, stocks have outpaced inflation over the long run, but that comes with risk,
which some investors may not want to take on.
One potentially less volatile strategy is investors could consider is value stock investing,
which is when an investor chooses stocks that may be underpriced.
Value companies are less likely than growth companies to borrow to produce future earnings,
which could lessen the impact of rising interest rates in response to inflation.
Dividend-paying stocks and REITs are alternatives as well.
Investors who lean toward real estate should consider a REIT’s holdings.
An MIT study from 2017 found that retail property income tends to provide the best hedge against
inflation when compared to industrial, residential, and office property.
But keep in mind that investments in REITs and other real estate securities are subject
to the same risks as direct investment in real estate, including loss of principal.
Some investors turn to gold and other precious metals, which have been considered a hedge
against inflation for a long time too.
A big reason some investors turn to metals is they’re real, tangible assets.
In theory, all the gold that has ever existed still exists.
There are several ways to invest in gold and other precious metals, like ETFs that track
the price of gold, investing in mining companies, or even buying physical bars.
You could consider other commodities like coffee or oil.
Inflation is typically tied to increased demand for goods and services, which is often good
news for commodities.
To get exposure, some investors might consider related stocks or ETFs that track certain
commodities.
But commodities are not for everyone; they can be extremely volatile and are often tied
to world events, competition, government regulations, and economic conditions.
Some investors are turning to the new kid on the block: cryptocurrency.
Bitcoin evangelists like Elon Musk believe that crypto is less susceptible to the effects
of inflation because it has a certain number of coins that can be circulated; it
can’t be watered down.
The thing is they’re still very new and very volatile investments, which makes it
hard to draw conclusions.
Bitcoin hit all-time highs in April 2021, but it also saw major drops that month and
in May 2021, while inflation expectations ballooned.
So, the jury is still out on whether cryptocurrency could act as a hedge against inflation over
the long term.
Bitcoin and other cryptocurrencies are very speculative investments.
They involve a lot of risk and may not be suitable for everyone.
Each inflationary period is different.
In the early 20th century, most high inflation periods were tied to wars mainly the two
world wars.
The Great Inflation a period from the 60s to the start of the 80s saw high inflation
that led to the rethinking of central banking.
Regardless of how much you think inflation will rise, varying your holdings may offer
some protection.
You’ll need to do your own research to determine which kind of assets you might offer the best
hedge for your portfolio.