With ongoing remaining spending and a sharp increase in economic growth following the outbreak of the COVID-19 virus, inflation is a common concern for many people. When inflation occurs, prices rise, money loses its purchasing power, and the value of dollars in your wallet decreases.
Avoid High Amounts of Long-term Bonds
When it comes to rising inflation rates, bonds are the least secure asset class. Bond investors are affected by inflation risk because bonds are fixed-income investments.
Most bonds receive a fixed interest rate that does not change. People buy bonds because their income payments will not decrease, but they also will not increase. When the purchasing power of the dollar declines, your bond income also decreases. You will receive the same amount of money with each payment, but those payments will not buy much.
If you buy a 30-year bond paying an interest rate of 4%, but inflation rises to 12%, you have a problem with bonds. With each passing year, you will lose purchasing power increasingly, regardless of how secure you feel about your bond investments.
There are two ways you can reduce the impact of inflation on your portfolio if it contains bonds. The first way is to buy short-term bonds. Bond payments depend on the interest rate at the time they are issued. If your bond matures in a few months instead of years or decades, the risk is limited to how much inflation can happen in those months.
The second way you can reduce bond risk is by purchasing Treasury Inflation-Protected Securities (TIPS). These bonds reset their balance twice a year to account for inflation and deflation. When inflation rises, your interest payments increase, and vice versa. When the TIPS you own mature, you will receive either your original capital investment or the inflation-adjusted capital, whichever is greater.
Own Investments with Pricing Power
If costs increase due to inflation, some companies have an easier time passing those costs onto customers. This is known as pricing power, and it can significantly impact a company’s ability to maintain profits during tough times.
For example, think about how McDonald’s can raise the prices they charge for Big Macs and fries. People who frequently eat at McDonald’s are unlikely to give it up due to price increases. An insurance company can charge higher premiums, and the person needing insurance will have to purchase it. A landlord can raise rents, and many tenants will pay the higher rent rather than try to find a new place to live.
These are examples of companies that have some embedded protection from high inflation rates. If you own stocks and bonds in companies with pricing power, you can survive periods of high inflation without much damage to your investments.
Pricing power does not only apply during inflationary periods. If demand drops for any reason, a company with pricing power will be able to raise costs to avoid losing revenue.
Consider Commodities
Commodities are raw materials that have value. Wheat, corn, oil, gold, silver, and copper are all commodities. Wheat can be eaten; therefore, it has value regardless of the value of the U.S. dollar. Oil can be used as an energy source. Gold and silver have uses in manufacturing, and they also have a history of serving as a store of value that does not depend on a specific currency.
Although it is not a commodity, real estate is also seen as a means of similar protection against inflation. The value of land is not tied to a specific currency. Fine art and antiques also have a level of protection.
Most
People cannot store barrels of oil or gold bars in their homes, but they can add commodities to their portfolios by using exchange-traded funds (ETFs) or derivatives such as futures and options.
Since the values of these types of commodities do not depend on any other aspect of the economy, their prices move more independently. However, this does not mean that prices always move upwards. Gold, for example, may act as a hedge, but gold prices can also fall, and you could lose your original investment.
Conclusion
You can take steps to restructure your portfolio that may help defend against purchasing power. Some people may find ways to benefit from inflation. However, it is important to talk with your financial advisor to discuss these plans in more depth.
Source: https://www.thebalancemoney.com/inflation-risk-management-strategies-357604
Leave a Reply