Every investor faces the risk of inflation. Inflation is the process by which money loses its value over time. This is why you may have heard your grandparents talking about buying a loaf of bread for a nickel when a loaf of bread costs a dollar or two today.
How does inflation hedging work?
Hedging against inflation means taking steps to protect the value of an investment from the effects of inflation.
For example, if you have an asset that increases in value by 3% per year, but inflation is 4%, the real return on that asset is actually -1%. The Federal Reserve typically targets a long-term average inflation rate of 2%, but there have been periods in the past where inflation exceeded 17% annually.
There are a few ways to try to hedge against inflation. One option is to buy assets whose value is usually linked to inflation. If inflation rises, their value will increase in tandem. Another way is to invest in securities specifically designed for inflation protection. For example, some bonds may pay an interest rate that is partly based on the rate of inflation.
What investments do investors typically use to hedge against inflation?
Here are some investments that investors use to hedge against inflation:
Gold
Gold and other precious metals are among the most well-known assets when it comes to hedging against inflation. Many global currencies in the past were backed by gold, and it has a place in many investors’ portfolios.
In fact, gold is not the best hedge against inflation. Although it typically follows inflation, there have been periods when its price moved out of sync with inflation. For example, between 1980 and 1984, gold lost 8.3% of its value annually while average inflation was 7.5% per year.
Note: Cryptocurrencies have gained some popularity as a hedge against inflation because they are considered limited assets similar to gold coins. However, cryptocurrencies are highly volatile, making them more speculative assets than a hedge against inflation.
Inflation-Protected Securities
Inflation-Protected Securities are a type of U.S. government bond specifically designed to help investors hedge against inflation. Like other bonds, investors can buy inflation-protected securities by lending money to the government. In return, investors receive interest. You can also invest in ETFs that are linked to inflation-protected securities if you prefer not to buy individual bonds.
Inflation-Protected Securities have a fixed interest rate, but they adjust the principal value of the bond based on inflation, as determined by the Consumer Price Index (CPI). When the CPI rises, the principal value of the bond is adjusted upward, meaning investors earn more interest and receive more money when redeeming their bonds. These bonds work both ways, however. If deflation occurs, the principal amount decreases, along with the interest payment.
Variable Rate Bonds
A variable rate bond is a bond that carries a variable interest rate. The bond’s rate typically changes on a regular basis (such as annually) based on fluctuations in a reference rate. For example, the bond may pay a rate equal to the London Interbank Offered Rate (LIBOR) plus 2%.
Central banks often adjust reference interest rates in response to changes in inflation. When inflation rises, a common response from the central bank is to raise interest rates, which discourages spending and reduces inflation. This means that variable rate bonds often see their interest rates rise with increasing inflation and fall with decreasing inflation rates. Rather than purchasing the bond itself, you may consider investing in ETFs linked to variable interest rates or bond funds.
Stocks
Stocks represent
Stocks represent ownership in businesses. Typically, businesses are forced to raise the prices of the goods and services they sell when inflation rises, which increases their revenues and can subsequently lead to higher stock prices.
Stocks generally do well in keeping up with inflation. However, they also face more price fluctuations compared to other assets, so investors should be prepared to accept volatility risk when investing in stocks.
When the Federal Reserve raises interest rates to control inflation, it becomes more difficult for companies to borrow. This may affect their production and ultimately their profits. However, some sectors like financial services may benefit from rising interest rates. After all, banks and lenders have the opportunity to profit from the interest they charge on loans. Look into exposure to such sectors, either by investing in specific stocks or sector-specific equity funds or exchange-traded funds linked to the sector.
Real Estate
Real estate is another common hedge against inflation. Buying real property means that investors who own their homes no longer have to worry about rising rents.
Instead of buying a home, real estate investments can help combat the effects of inflation. Since 1990, investing in real estate, via real estate investment trusts (REITs), has proven to be an effective hedge against the impact of inflation.
Commodities
Commodities like oil and corn are another common hedge against inflation. It stands to reason that when money loses purchasing power, the price of commodities, including goods, should rise.
This means that direct investment in commodities, or companies heavily involved in commodities, can help investors hedge against inflation as the value of those commodities tends to increase when inflation occurs.
What Does This Mean for Individual Investors?
Inflation affects everyone. Whether you have one dollar or one million dollars, inflation slowly erodes the purchasing power of your money.
Individual investors, especially those with long-term investment plans, should consider how inflation will impact their investments. This may mean allocating a portion of your portfolio to hedge against inflation or choosing a more investment-minded asset allocation to increase returns.
Frequently Asked Questions (FAQs)
Why is gold considered a hedge against inflation?
Gold is a tangible asset, and many investors believe that precious metals and other physical assets generally see their values move in tandem with inflation, although this has not always been the case.
Why is real estate considered a hedge against inflation?
For those who own their homes, real estate helps hedge against rising rents.
The cost of shelter, such as renting a house, is included in the inflation calculation in the U.S., but when someone buys a home, they typically use a mortgage that locks in their payment for many years. Those who own their homes outright only need to pay property taxes, which change less than rent.
For investors, many types of real estate, especially commercial properties, have served as effective barriers against inflation, contributing to real estate’s overall reputation as an effective hedge.
What type of investment contracts allow you to hedge against inflation?
Insurance contracts typically provide regular, fixed payments to investors, who can use those payments to cover living expenses. Over time, inflation can impact the value of those payments.
They provide
Many insurance sellers offer contracts with cost-of-living adjustments, or inflation-protected insurance contracts, that increase payments based on changes in inflation. These types of insurance contracts may cost more or provide lower initial payments, but they offer protection against inflation.
Which bonds provide the greatest protection against inflation?
Treasury Inflation-Protected Securities (TIPS) are the most likely bonds to provide protection against inflation. This is because they are specifically designed with inflation in mind.
The U.S. government adjusts the principal value of TIPS based on inflation determined by changes in the Consumer Price Index. When inflation rises, the principal value of TIPS increases at a higher rate, meaning that more interest will accrue and you will receive more money when the bonds are redeemed.
The Balance does not provide tax, investment, or financial services and advice. Information is provided without regard to the investment goals, risk tolerance, or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of losing original capital.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
Henry Neville, Teun Draaisma, Ben F. van Niel, Campbell R. Harvey, Otto van Hemert. “The Best Strategies for Inflationary Times,” page 3. SSRN.
Federal Reserve Bank of Dallas. “The Fed’s New Inflation Targeting Policy Aims to Keep Well-Anchor Expectations.”
TreasureDirect. “Treasury Inflation-Protected Securities (TIPS).”
Invesco. “Why REITs May Help Hedge Your Portfolio Against Inflation.”
Henry Neville, Teun Draaisma, Ben F. van Niel, Campbell R. Harvey, Otto van Hemert. “The Best Strategies for Inflationary Times,” page 13. SSRN.
Source: https://www.thebalancemoney.com/how-to-hedge-against-inflation-5192689
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