How To Mitigate the Threat of Inflation in a Portfolio

A financial planner sits at a table with a couple where they look at a computer
•••

10'000 Hours / Getty Images

With ongoing deficit spending and a sharp uptick in economic growth after COVID-19 hit, inflation is a common concern of many people. When inflation hits, prices increase, money loses purchasing power, and the value of the dollars in your wallet decreases.

How can you lessen the impact of high inflation rates? What can you do to protect your wealth so that you can sleep soundly at night? There are no foolproof methods, but there are some things you can look at with the help of a good financial planner. If done the right way, these moves may help reduce your risk from the effects of inflation.

Learn about three methods for fighting inflation: scaling back on long-term bonds, owning stocks with pricing power, and investing in commodities.

Avoid a High Amount of Long-Term Bonds

When it comes to inflation rate hikes, bonds are the most unsafe asset class. Bond investors are affected by inflationary risks because bonds are fixed-income investments.

Most bonds receive a fixed coupon rate that doesn't change. People buy bonds because the income payments won't decrease, but they won't increase either. When the buying power of the dollar declines, your bond income also decreases. You'll still receive the same amount of money with each payment, but those payments won't buy as many things.

If you buy a 30-year bond that pays a 4% interest rate, but inflation goes up to 12%, you are in trouble with bonds. With each passing year, you are losing more and more buying power regardless of how safe you feel when you invest in bonds.

There are two ways you can reduce the impact of inflation on your portfolio if you have bonds in it. The first is to buy shorter-term bonds. Bond payments are based on the interest rate at the time they're issued. If your bond matures in a matter of months rather than years or decades, the risks are limited to how much inflation can occur in those months.

The second way you can limit bond risk is to buy Treasury Inflation-Protected Securities (TIPS). These bonds recalibrate twice per year to account for inflation and deflation. When inflation goes up, your interest payments increase and vice versa. When TIPS you own mature, you'll get back your principal investment or the inflation-adjusted principal, whichever is greater.

Own Investments With Pricing Power

If costs increase as a result of inflation, some firms have an easier time passing those costs onto customers. This is known as pricing power, and it can have a big impact on a company's ability to keep profits steady in hard times.

For instance, consider how McDonald's can increase the prices they charge for Big Macs and fries. People who eat McDonald's often aren't likely to give it up over a price hike. An insurance company can charge more in premiums, and someone who needs insurance will still have to buy it. Baring rent-control laws, an apartment building owner can increase rents, and many tenants will pay the higher rent price rather than try to find a new place to live.

These are examples of businesses that have some built-in shelter from a rise in the inflation rate. If you own stocks and bonds in companies with pricing power, you can survive bouts of high inflation without a lot of damage to your investments.

Pricing power doesn't only apply to inflationary periods. If demand falls for any reason, a company with pricing power will be able to raise costs to avoid losing revenue.

To retain pricing power, a company must keep coming up with new things and stay at the top of its industry. When competitors begin offering similar products with similar levels of quality, leaders in the space lose pricing power.

Look at Commodities

Commodities are raw materials that have value. Wheat, corn, oil, gold, silver, and copper are all commodities. Wheat can be eaten, so it has a value no matter what the U.S. dollar is worth. Oil can be used as a source of power. Gold and silver have manufacturing uses, and they also have a history of serving as a store of value that doesn't depend on a specific currency.

Though not a commodity, some people consider real estate to offer a similar hedge against inflation. The value of land isn't tied to a specific currency. Fine art and collectibles also have a level of protection.

Most people can't store barrels of oil or bars of gold in their homes, but they can add commodities to their portfolios through the use of commodity ETFs or derivatives like futures and options.

Since the values of these types of goods don't depend upon any other aspect of the economy, their prices move more independently. Still, that doesn't mean the prices always move up. Gold may work as a hedge, for instance, but the price of gold may also fall, and you could lose your principal investment.

The Bottom Line

You can take steps to retool your portfolio that may help defend against a loss in purchasing power. Some people may even find ways to profit from inflation. Still, it's vital to talk with your financial planner to discuss these plans more in-depth.

Article Sources

  1. Office of Investor Education and Advocacy. "Bonds."

  2. TreasuryDirect. "Treasury Inflation-Protected Securities (TIPS)."

  3. Morgan Stanley. "Exploring Pricing Power," Page 2.