Inflation is a risk every investor faces. Inflation is the process through which money tends to lose value over time. It’s why you might have heard your grandparents talk about buying a loaf of bread for a nickel when a loaf of bread costs a dollar or two today.
There are many ways for investors to hedge, or protect, against inflation, including some investments designed specifically for hedging against inflation. Learn more about assets that are used as inflation hedges and how they can fit in your portfolio.
- Inflation is the process through which a currency tends to become less valuable over time.
- Investments are subject to inflation risk: Inflation reduces an investment’s value over time unless returns outpace inflation.
- Many investors turn to different types of investments specifically to hedge against inflation.
How Does Hedging Against Inflation 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% each year, but inflation is 4%, the real return of that asset is actually -1%. Typically, the Federal Reserve targets a long-term average inflation rate of 2%, but there have been periods in the past where inflation surpassed 17% per year.
There are a few ways to try to hedge against inflation. One option is to purchase assets whose value tends to be tied to inflation. If inflation rises, their values will rise in tandem. Another is to invest in securities specifically designed to hedge against inflation. For example, some bonds will pay an interest rate partially based on the rate of inflation.
What Do Investors Typically Use To Hedge Against Inflation?
These are some of the investments investors use to hedge against inflation.
Gold and other precious metals are among the most commonly thought-of assets when it comes to hedging against inflation. Many world currencies used to be backed by gold, and it still has a place in many investors’ portfolios.
In truth, gold is not the best inflation hedge out there. While it often keeps up with inflation, there have been periods where its price moves out of sync with inflation. For example, between 1980 and 1984, gold lost 8.3% of its value per year while inflation averaged 7.5% per year.
Bitcoin has gained some popularity as an inflation hedge because it is seen as a limited, currency-like asset, similar to gold. However, cryptocurrencies are highly volatile, making them more speculative assets than inflation hedges.
Treasury Inflation-Protected Securities, or TIPS, are a type of U.S. government bond explicitly designed to help investors hedge against inflation. Like other bonds, investors can buy TIPS by lending money to the government. In exchange, investors receive interest.
TIPS have a fixed rate of interest, but adjust the principal value of the bond based on inflation, as determined by the Consumer Price Index (CPI). When CPI rises, the principal value of the bond adjusts upward, meaning investors accrue more interest and receive more money when they redeem their bonds. These bonds work both ways, however. If deflation occurs, the principal amount drops, and so does the interest payment.
A floating-rate bond is a bond that has a variable interest rate. Typically, the rate of the bond changes on a regular basis (such as annually), based on changes in a benchmark rate. For example, a bond might pay a rate equal to the London Interbank Offered Rate (LIBOR) plus 2%.
Central banks often adjust benchmark interest rates in response to changes in inflation. When inflation rises, a common response from a central bank is to raise rates, discouraging spending and reducing inflation. This means that floating-rate bonds often see their interest rates rise with rising inflation and decrease with lower inflation rates.
Stocks represent an ownership stake in a business. Typically, as inflation rises, businesses have to charge more for the goods and services they sell, which increases their revenues and in turn, can cause their stock prices to rise.
Stocks generally do a good job of keeping pace with inflation. However, they also experience more price volatility than other assets, so investors need to be willing to accept volatility risk when investing in shares.
Real estate is another popular inflation hedge. Buying real property means that investors who own their homes no longer need to worry about rising rents.
Real estate investments, instead of purchasing a home, can also help investors fight the effects of inflation. Since 1990, real estate investment, via REITs, has effectively hedged against the impact of inflation.
Commodities, such as oil and corn, are another popular inflation hedge. Logically, when money loses purchasing power, the price of goods, including commodities must have risen.
This means that investing directly in commodities, or businesses heavily involved in commodities, can help investors hedge against inflation as the value of those commodities tends to rise when inflation does.
What It Means for Individual Investors
Inflation affects everybody. Whether you have $1 or $1 million, inflation slowly reduces the purchasing power of your money.
Individual investors, especially those who have long-term investment plans, should think about how inflation will affect their investments. That may mean dedicating a portion of your portfolio to inflation hedges or choosing a more aggressive asset allocation to help increase returns.
Frequently Asked Questions (FAQs)
Why is gold a hedge against inflation?
Gold is a physical asset, and many investors believe that precious metals and other physical assets have tended to see values move in tandem with inflation, although this has not always been the case.
Why is real estate a hedge against inflation?
For people who own their own homes, real estate helps to hedge against increasing rents. The cost of shelter, such as renting a home, is included in the calculation of inflation in the U.S., but when someone buys a home, they typically use a mortgage that has a payment that is locked in for many years. Those who own their homes outright need only pay property taxes, which tend to change less than rent.
For investors, many types of real estate, especially commercial real estate, have historically served as effective hedges against inflation, helping real estate as a whole gain its reputation as an effective hedge.
Which type of annuity lets you hedge against inflation?
Annuities typically offer regular, fixed payments to investors, who can use those payments to cover living expenses. Over time, inflation can cut into the value of those payments
Many annuity sellers offer annuities with cost-of-living adjustments, or inflation-protected annuities, which increase payouts based on changes in inflation. These types of annuities may cost more or offer lower initial payments, but provide a hedge against inflation.
Which U.S. savings bond is most likely to provide a hedge against inflation?
Treasury Inflation-Protected Securities (TIPS) are the most likely savings bonds to serve as a hedge against inflation. This is because they are designed specifically with inflation in mind.
The U.S. government regularly adjusts the principal value of TIPS based on inflation determined by changes in the Consumer Price Index. When inflation rises, the principal value of your TIPS will increase at a greater rate, meaning more interest will accrue and you’ll receive more money when redeeming the bonds.
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