How to Invest During Inflation
As of the most recent consumer price index (CPI) reading on Aug 10, inflation came in at 8.5% annualized. While the rate has come down from the 9.1% reading in June, it remains to be seen if this is a temporary step in the right direction or if inflation has in fact peaked. Any way you slice it, Americans are experiencing the worst level of inflation since the end of 1981.
While this issue has become very political, really it is a problem that was brought on by a confluence of factors – supply chain disruptions due to COVID, oil prices spiking because of Russia invading Ukraine, the Federal Reserve waiting too long to slow down the money supply, and the Federal government injecting a record amount of stimulus into the economy.
This begs the question being asked by most investors today… What can they do with their money while inflation is still running hot? Eventually the Fed will get things under control. Until then investors are in a predicament because there is a lot of noise in the media about the types of investments that generate returns in an inflationary environment. With that in mind, the objective of this article is to:
Provide an overview of the various investment strategies that may protect your portfolio during periods of rampant inflation.
Better define what investments work best and what investments are more of an inflation myth.
How to Protect Your Portfolio from Inflation
The Stock Market
While we are seeing a different story play out in 2022 than is typical – during past inflationary periods where inflation has exceeded 2%, most stock investments do well. Historically, the S&P 500 has generated about a 10.5% average annual return since its inception in 1957. The reason stocks tend to do well in an inflationary environment is that companies make more money when consumers are willing to buy more of their goods at higher prices.
More specifically, small stocks have outperformed large stocks, whereas growth stocks are often negatively impacted. That’s because higher interest rates, when the Federal Reserve is raising interest rates to fight off inflation, are counterproductive to companies that are borrowing money to accelerate growing their profits.
Commodities
Commodities such as metals, lumber, and oil typically increase in value during inflationary times. The challenge is that these types of assets are difficult to productively include in portfolios because the purest way to invest in them is by buying futures contracts, which most brokerage accounts do not support.
However, investors can gain access through commodity-based exchange traded funds (ETFs). The drawback to getting exposure via ETFs is that the expense ratios tend to be elevated compared to other investments; and there is a higher degree of tracking error – meaning that the price movements up or down do not follow the commodity futures prices 1-to-1.
Gold
One of the most sought-after hedges against inflation is buying gold. Unfortunately, gold is not a perfect hedge because it is purely a speculative investment that carries its perceived value by the holder. There is no real intrinsic value like there is with owning a stock.
In fact, gold’s record is spotty when it comes to combatting inflation. When we rewind back to 1980-1984 when inflation was 6.5%, gold investors actually lost 10%. On the flip side, investors in gold stood to earn 35% from 1973 to 1979, when inflation was averaging 8.8%.
Based on the chart below, “How different assets historically respond to inflation,” it’s evident that owning gold as an inflation hedge tends to work best within a very narrow window – when inflation is high and rising. The other 3 scenarios in the chart (occur 74% of the time) indicate that investing in gold is a gamble, especially when compared to the other asset classes.
Real Estate Investment Trusts (REITs)
If you are a homeowner, one of the positive takeaways in this economy is that your property value has seen significant growth during the last few years. Some of that is attributed to low amounts of supply relative to demand and historically low mortgage rates, however, another reason is that rents have been on the rise because of inflation. When rental rates go up, homeownership demand increases and the cycle of prices rising continues.
Aside from buying physical real estate, another way to gain exposure within your retirement portfolio is buying an investment vehicle called a Real Estate Investment Trust (REIT). REITs are a pool of real estate investments that pay regular dividends.
Effectively, REITS are a way to gain diversified exposure to an asset class that have held up well during most inflationary periods. The drawback to investing in REITs is that they are interest rate sensitive. Therefore, when rates are on the rise the risk is that they can experience an outflow from investors, as they seek lower risk investments that generate similar yields. Outflows can in turn lead to negative returns.
Treasury Inflation Protected Securities (TIPS)
TIPS are a type of US Treasury bond that are indexed to inflation. The fact that their interest rate is tied to inflation is a clear-cut way of protecting investors from rising prices. The interest coupon is paid twice per year, while the principal value of the bond fluctuates based on the inflation rate. Therefore, the principal adjustment and coupon make up the total return a bond investor will get. Investors can buy TIPs in maturities of 5-years, 10-years, and 30-years.
In general, TIPs can be used to supplement the fixed income portion of an investment portfolio. However, once inflation has peaked, TIPs are less appealing to own because of their direct link to the inflation rate.
Which Inflation Investment Works Best?
Media pundits frequently will trot out something like gold or commodities as your magic bullet solution to fighting inflation. Yet, it’s the stock market that has historically provided the best odds of success. The truth is that the other strategies produce a lesser degree of success, and that success is varied. In other words, most alternative investment strategies are really clickbait more than anything else.
A tactical position in gold or oil from time to time may be beneficial, however, knowing when and how much to put into your portfolio is a risk-reward tradeoff that is best left to a professional. Otherwise, you might be exposing your nest egg to a greater amount of risk than what you might be able to afford, especially if you are taking distributions during retirement.
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IMPORTANT DISCLOSURE INFORMATION
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