At EsqWealth, we start with developing a long-term comprehensive financial plan which is customized to each client’s needs and risk tolerance. Our plans take into consideration the effects of inflation, so we often encourage our clients to stick to the plan. However, it’s called “financial planning” for a reason: assumptions turn out different than reality and plans evolve over time. We stay on top of key assumptions in the plan and recommend that it be tweaked from time to time.
The Consumer Price Index (CPI), climbed to 7.5 percent in January, its highest level in four decades. As a result, many investors have become increasingly worried about how inflation might impact their plan. Inflation can be a problem because it decreases the spending power of every dollar saved—over the long-term, your money won’t stretch as far. Luckily, there are steps you can take to adjust your plan to hedge against inflation. Of course, each person has different long-term goals, different timelines, and different risk tolerances. Thus, each strategy may or may not work for you or fit with your long-term goals. With that said, below are five investment strategies that have been traditionally considered good hedges against inflation.
1. Stay invested in stocks
Inflation is a normal part of the market, but during times of high inflation, it’s worth revisiting your portfolio to determine if it still meets your desired rate of return and risk tolerance. Stocks offer higher potential returns, which can help you outpace the rate of inflation. But they can also be volatile. Consider holding a greater portion of stocks to take advantage of higher returns if your risk tolerance allows it.
2. Minimize exposure to traditional bonds
The Federal Reserve will likely raise interest rates this year in an effort to control inflation. Traditional bond prices are inversely related to interest rates. In other words, when interest rates rise, bond prices usually decrease. As a result, during times of high inflation, you may want to avoid overexposure to bonds in your portfolio, as they can rapidly decrease in value when interest rates rise.
3. Consider TIPS
Treasury inflation-protection securities (TIPS) are a type of U.S. Treasury bond designed to keep pace with inflation. TIPS are backed by the U.S. government and considered some of the safest investments available. When you buy TIPS, you are lending money to the government and receiving interest in return in the form of a coupon payment. The principal value of TIPS is indexed to the rate of inflation. When inflation rises, the principal value does too, which in turn increases your coupon payment. When inflation falls, the principal value decreases, and coupon payments decrease as well. You can buy TIPS with maturities of five years, 10 years, and 30 years.
4. Invest in real estate
Historically, real estate has done well during inflationary periods largely because as inflation rises, landlords are able to pass higher costs on to their tenants. In the current market, however, you need to be mindful of the recent surges in residential home prices over the past two years, whether that will continue, and what effect increases in interest rates will have on that market. Some suggest that we are in a real estate bubble while others believe that the increase in real estate prices will just level off. If you decide to invest in real estate, you can do so directly by becoming a landlord and collecting rent on properties you own. Or you can invest indirectly by buying shares in real estate investment trusts, or REITs. REITs are companies that own and manage real estate, such as office buildings, apartments, or retail spaces. The companies generate income by collecting rent. They then pass the profits on to their shareholders. By law, REITs must pass 90% of their profits to their shareholders.
5. Explore commodities
The price of commodities, such as oil and corn, tends to rise with inflation, making commodities a popular inflation hedge. You can invest in commodities through mutual funds or exchange-traded funds that hold diversified baskets of investments. Another way to take advantage of the positive correlation between commodities and inflation is to invest in businesses heavily involved in commodities, such as mining companies, for example.
Remember that your investment portfolio is constructed based on your long-term goals, risk tolerance, and time horizon. Avoid making rash investment decisions based on potential short-term changes in the economy. Be sure any hedging strategies you use fit your overall plan and help you stay on track to meet your financial objectives.