How to Hedge Against Inflation – The Best Inflation Hedges
How to Hedge Against Inflation – The Best Inflation Hedges
12 October 2022
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How Can We Hedge Against Inflation?
Unfortunately, every investor risks facing inflation ever in their whole life – a process that leads money to lose value over some time. That’s actually the reason why you’ve heard your grannies talk about buying a loaf of bread for a nickel while its cost is about a dollar or two today.
The great news is that this problem has a solution. Nowadays, there are multiple ways to hedge against inflation – you just need to know which ones exactly, and how many of them truly work. If you’re willing to learn all the key details, you’ve come to the right place – today, we’re going to provide you with the answers to all of your questions. So let’s not waste time and check!
What is an Inflation Hedge?
Let’s start with the basics – what is actually an inflation hedge?
An inflation hedge is an investment that allows the investors to secure themselves. In other words, they avoid the declining purchasing power of money because of the increasing prices of goods and services. Those investments that save their costs during inflation, as well as increase the value over a while are considered the perfect ones for hedging against inflation.
Usually, the investors choose gold or real estate to protect themselves against inflation. Nevertheless, many prefer to invest in stocks, hoping to compensate for inflation in the long term.
Why Companies Hedge Against Inflation
The main question is the following: why do companies actually need it? Below you’ll see the reasons why investors require hedging against inflation:
Protect the Value of Their Investment
First of all, people need to secure their investments from loss of value during the inflation period. Some investments add value during normal economic cycles, however, decrease during inflationary cycles after the inclusion inflation impact.
To avoid such a problem, it’s advised to choose stable investments only that save and increase the value during periods of inflation. For instance, real estate is considered one of the best ways to hedge against inflation since the rental income, as well as the market value of real estate properties usually maintain or grow in value during the period of inflation.
Let’s have a look at the example. An investor can acquire the investments with an annual return of 5%. Nevertheless, at the end of the year, the investment rate speeds up to 6% when the investor is planning to sell the investments. What does that actually mean? The investor will take the loss of 1%, which is a loss in their purchasing power.
Keep Operating Costs Low
When a company forecasts that its operating costs will grow during the inflation period, it might make investments that can lower them. As a rule, inflation leads to an increase in the costs of producing goods and services, which results in a decrease in portfolio returns. To find a solution, companies can be forced to increase prices for their products, cut their operating costs, or even accept reduced margins.
Here’s an example: during inflation, oil supplies fluctuate while its costs rise, leading to the situation where airlines are forced to increase their operating costs significantly. Oil is the main cost, and a rise in oil prices can considerably impact the profit margins of these companies.
Airline companies can participate in inflation hedging by purchasing oil refineries to lower the risk of fuel price hikes. Thus, they’re producing jet fuel for their planes and jets instead of buying it from suppliers at the market rate.
What Do Investors Use to Hedge Against Inflation?
Want to know how it’s possible to stay hedged against inflation? If so, let’s have a look at the best options investors use to protect themselves – below are all the key details about each one.
Currently, gold, along with other precious metals, is still the most frequently covered asset if we speak about hedging against inflation. Several world currencies were earlier provided with gold, so it still takes the place in many investors’ portfolios.
However, bear in mind the following: there might be periods when gold’s price doesn’t synchronize with inflation. For example, between 1980 and 1984, gold lost 8.3% of its value per year. At the same time, inflation averaged about 7.5% per year.
Most bonds aren’t the best choice for inflation protection. The reason is that these investments pay a fixed rate of interest over time. Their prices may change in the secondary market, but the interest rate they pay is usually unadjusted.
At the same time, there are Treasury Inflation-Protected Securities (TIPS) with inflation protection. Their interest payments rise with inflation and fall during periods of deflation. Like other bonds, investors can buy TIPS by lending money to the government. In return, investors receive interest. You can also invest in TIPS ETFs if you don’t want to buy individual bonds.
If you have invested in something that has a fixed rate, you are likely to lose money when inflation hits. Floating-rate bonds give your money a better chance of surviving and even generating income because it will grow to follow inflation.
How does it actually work? In most cases, central banks correct benchmark interest rates in reply to inflation changes. When inflation grows, they used to raise rates to avoid spending, as well as reduce inflation. This means that floating-rate bonds often grow and decrease together with inflation. In addition, instead of purchasing the bond itself, you can consider another option – investing in floating rate ETFs or bond funds.
For the most part, stock returns exceed inflation. As prices rise, so do companies’ profits, which means the value of their shares rises. In the long run, the stock market has almost always yielded returns above the rate of inflation.
Passive index investing is the easiest way to invest in stocks, and it doesn’t depend on your ability to pick them. Stocks of companies in the technology sector and growth-oriented stocks are the most reliable protectors. It’s also worth adding consumer goods and essential stocks to your bond portfolio.
Housing prices, like commodity prices, usually rise in parallel with increases in the prices of goods and services. If you can’t buy a home, real estate investment trusts may be right for you – these are publicly traded property portfolios; although they’re technically securities, they’re influenced by real estate trends.
According to Adem Selita, CEO of Debt Relief Company, in times of inflation above 3.3%, commodities are a great investment. Cereals, raw materials, or natural resources are real assets. Their prices always go up in such conditions.
Let’s have a look at BTC. Since Bitcoin is considered a limited, currency-like asset, similar to gold, it became pretty popular regarding the protection from inflation. Nevertheless, cryptocurrencies are quite volatile, which means they’re more speculative assets rather than inflation hedges.
What it Means for Individual Investors
Inflation impacts absolutely everyone. It doesn’t matter how much money you have – it slowly decreases the purchasing power of your budget.
If you’re an individual investor, you should definitely think about the inflation influence on your investments, especially if you have long-term plans. Actually, you can consider two ways to solve all the problems:
Allocate a part of your portfolio to inflation hedges,
Choose a more aggressive asset distribution to help raise the returns.
The Bottom Line
It doesn’t even matter what actually causes inflation – consumer demand and healthy economic activity, or, sometimes, money printing and lack of resources. Since there are many great ways to hedge against inflation, you don’t have to worry about that. Using every possible opportunity, such as investments in stocks or gold and property purchases, you’ll definitely sleep well at night.
We sincerely hope that our detailed guide helped you. Now, you know everything you need to know about keeping yourself safe from inflation: what an inflation hedge is exactly, why companies actually need it, what are the best options to protect yourself, etc. Just keep in mind one crucial thing: if you need help, you can always come back to this article and refresh your memory. So thank you for reading, and invest wisely!
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