How to Mitigate the Threat of Inflation in a Portfolio

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

How can you mitigate high inflation rates? What can you do to position your family's wealth in a way that you can sleep soundly at night? There are no foolproof methods, but there are some things you can consider with the help of a good financial planner. If executed properly, they have the potential to reduce your risk from the effects of inflation.

Keep reading to learn about three methods for combating inflation: scaling back on long-term bonds, owning stocks with pricing power, and investing in commodities.

Avoid a High Concentration of Long-Term Bonds

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

Most bonds receive a fixed coupon rate that doesn't change. Investors buy bonds because the income payments won't decrease, but they won't increase either. When the purchasing power of the dollar declines, your bond income effectively 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 skyrockets to 12%, you are in serious trouble. With each passing year, you are losing more and more purchasing power regardless of how safe you feel when investing in bonds.

There are two ways bond investors can reduce the impact of inflation on their portfolios. The first is to buy shorter-term bonds. Bonds establish payments based on the interest rate environment at the time they're issued. If your bond matures in a matter of months, rather than years or decades, the inflationary risks are limited to how much inflation can occur in those months.

The second way bond investors can limit inflationary 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 companies have an easier time passing those costs onto customers. This is known as pricing power, and it can have a significant 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 suddenly over a price hike. An insurance company can charge more in premiums, and someone who needs insurance will buy it anyway. Baring rent-control laws, an apartment building owner can increase rents, and many tenants will simply 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 protection from a rise in the inflation rate. If you own companies with pricing power, you can survive bouts of high inflation without significant damage to the underlying fundamentals of 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 continue to innovate and stay at the forefront of its industry. When competitors begin offering similar products with similar levels of quality, leaders in the space lose pricing power.

Consider Commodity Investments

Commodities are raw materials that have value. Wheat, corn, oil, gold, silver, and copper are all examples of 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 independent of any specific currency.

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

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

Since the values of these types of goods aren't dependent upon any other aspect of the economy, their prices move more independently. However, that doesn't mean the prices always move up. Gold may work as an inflation hedge in some instances, for example, but the price of gold may also fall, and an investor could lose their principal investment.

The Bottom Line

There are steps you can take to reposition your investment portfolio that may help defend against a loss in purchasing power. Some investors may even find opportunities to profit from inflation. However, it's important to talk with your financial adviser to discuss these strategies more in-depth.