Inflation concerns around the world are forcing investors to reexamine their investment portfolios. And for good reason. While inflation is a natural occurrence in any economy, it can also eat away at your investment returns if you’re not careful. This is why many investors are taking steps to hedge against inflation.
What is inflation? In basic terms, inflation occurs when the prices of goods and services continue to rise. This can cause a decrease in the value of currency. A quick look at how prices have increased over the last year shows that investors are right to have concerns.
Year-over-year increases from October 2021 to October 2022.
- Food: 95% increase
- Airline tickets: 43% increase
- Health care costs: 20% increase
- Utilities: 20% increase
- Gas: 17% increase
Additionally, the Consumer Price Index, although smaller than in previous months, still saw an increase of 7.7% for October 2022.
Along with rising prices, inflation also can spur higher interest rates, as seen over the last year. In fact, the Federal Reserve has increased interest rates at the last six consecutive meetings, with a three-quarter point raise for the last four. Interest rates on federal funds now stand between 3.75% and 4.00%.
With so many inflation signs in place, now is the time for investors to take steps to hedge against inflation. This guide provides more information about inflation's impact on investments. It also provides steps you can take to protect your interests.
How Has Inflation Affected Investment Returns?
The goal of the Federal Reserve rate hikes is to slow spending, but it can also hinder individuals’ as well as businesses’ ability to borrow money. Some longstanding companies are likely to weather these interest rate hikes just fine. However, startups and growth companies may find it difficult to secure the funds they need to grow their businesses.
Additionally, a natural result of inflation is a reduction in consumer spending. Historically, inflation prompted a lower return on equities. This is especially true for companies selling nonessential goods and services.
Growth stocks, in particular, can also be quite risky during an inflationary period and are often ignored by investors. When prices and interest rates rise, fixed-rate debt securities also tend to lose value.
As signs of inflation continue to show, many investors are developing strategies for hedging their investments.
How Has Inflation Affected Investments in the Past?
America has experienced six major periods of high inflation since World War II, with the last episode occurring in 2008. Due to this fact, many new investors are experiencing high inflation for the first time. This doesn’t mean that investors of all ages can’t learn from the past.
The first thing history shows is that investors tend to make knee-jerk decisions during inflation. These investors are trying to protect their interests. However, making rash decisions without a strategy can also damage your investment. One thing is certain: During inflation, the value of cash decreases. So, converting your assets into cash isn't the best option either.
Instead, it’s important to look at the past to see what types of investments perform well during inflationary times. Historically speaking, commodities such as oil and gold as well as mid-to-short-term cap stocks and REITs tend to perform well during periods of high inflation. Other investments, such as fixed-rate bonds and growth stocks, tend to underperform.
Ways to Hedge Against Inflation
The last thing you want to do is wait and see what happens. You've put your hard-earned money into these investments; it’s crucial that you take the necessary steps to protect your interests. Here’s a look at several steps you can take today to hedge against inflation.
The first thing you should do is evaluate your current investment portfolio. You may find you need to reallocate some of your investments to protect your interests during this time of instability. Many experts agree that a 60/40 stock-bond ratio is a good combination when weathering inflation.
So, if right now you’re holding onto a high number of stocks, it might be time to reallocate some of these funds into bonds. However, it’s best to invest in short-term bonds that can handle fluctuations in inflation better rather than long-term bonds that could lose value over time.
You might also consider shifting some of your stocks to more inflation-resistant ones. For example, you may want to let go of some growth stocks and instead invest in preferred stocks or utility stocks. These stocks are likely to deliver better short-term results.
One of the best ways to hedge against inflation is through a diversified investment plan. In other words, don’t put everything you have into just one type of investment. You can start by moving your emergency fund into a high-yield savings account, if you haven’t done so already.
As far as other investment options go, don’t just focus on stocks and bonds. Instead, you can also consider investing in gold and other precious metals. These metals tend to hold their value despite ongoing inflation. Inflation-adjusted treasury bonds, which adjust to overcome the risk of inflation, are another good option.
Real estate is almost always a good investment during periods of high inflation. This is because there's always a demand for real estate. However, keep in mind that real estate isn't a liquid investment, so you may not be able to easily convert it back into cash if you need to.
An alternative investment option is REIT, or real estate investment trust. This option allows you to invest in real estate during high inflation levels without the disadvantage of illiquidity. Investors buy, sell and trade REITs daily, so you can quickly convert this investment back to cash if needed.
What Should You Invest in During Inflation?
There are several investment options that you want to pay close attention to during periods of high inflation. Many investors rank these investments as some of the best ways to hedge against inflation.
Many investors believe commodities, such as grain, gold, natural gas and oil, are highly desirable during inflation. The reason for this is that the high consumer demand for these goods and services helps keep their prices high even as other prices start to fall.
However, other investors believe commodities aren't a risk-free way to hedge against inflation. Instead, they believe investors must carefully examine each commodity because its ability to withstand inflation price drops primarily depends on supply and demand.
Some novice investors erroneously believe you should pull out of the stock market altogether when inflation is high. However, this isn't always the best investment method.
Should You Invest During Inflation?
Buffett recommends only investing in companies with goods or services that can withstand inflation. For example, stock in natural gas can be a good investment because people will always need to heat their homes, no matter how high prices go. Secondly, look for companies that can meet production demands with little additional investment. This includes companies with a proven track record for delivering products on time.
Reviewing Your Retirement Plans (401ks)
Despite inflation, there's no need to stop contributing to your 401k plan. This is especially if your employer matches your contributions. Instead of stopping your contributions, take some time to diversify your plan’s investment options. For instance, you may want to reallocate some of your investments into mutual funds and short-term bonds, since these investments tend to do well during inflation.
Taking steps now to hedge against inflation can protect your assets. Knowing where to allocate your investments and when can be quite complicated, especially if this is your first time wading through a period of high inflation. To better understand your options and how these options can impact your overall investment portfolio, it’s best to talk to a financial adviser who can guide you through the process.