The inflation worries that have been building up among investors have finally become a reality.
While the Federal Reserve is calling inflation “transitory,” there is still more room for growth as the economy fully reopens. There will be pent-up consumer demand, which has already put pressure on prices and increased the cost of household goods and services.
According to a recent release from the U.S. Department of Commerce’s Bureau of Economic Analysis, inflation, as measured by a gauge preferred by the Fed, increased 3.6% in April from a year ago. A rate this high has not been seen since the Great Recession.
Savvy investors want to make sure to address inflation because if they don’t, it can decrease their purchasing power.
“Inflation over the long run is going to happen,” says Grace Yung, board ambassador for the Certified Financial Planning Board and managing director at Midtown Financial Group based in Houston. “And we have to keep up with that, and therefore, we have to build portfolios that outpace inflation.”
So, how should you be prepping your portfolio in an inflationary environment? Here are some effective asset classes that can help with capital preservation:
— Treasury inflation-protected securities
— Real estate
Treasury Inflation-Protected Securities
Treasury inflation-protected securities, or TIPS, are investments that account for inflation. More specifically, they’re inflation-protected bonds whose principal rises when there is inflation and falls when there is deflation. They pay interest twice a year at a fixed rate, which is applied to the adjusted principal. These interest payments increase with inflation and decrease with deflation.
The difference between the rate of inflation and the nominal interest rate is your real rate of return. TIPS are worth the investment if the return on investments minus inflation yields positive.
The concern may be that if inflation is lower than expected, the return on conventional bonds may be better. Experts say that if interest rates don’t increase, it could be a good time to move out of TIPS.
“If inflation does not rise very aggressively, be ready to diversify away from TIPS,” says Mike Schudel, a financial advisor at Retire Smart, a financial firm in Omaha, Nebraska.
Even though TIPS are a well-known inflation hedge, because their yields are so low, they may not be as appealing.
The solution: You don’t have to choose just one inflation hedge, you can have multiple inflation-protected securities in your portfolio.
“Historically speaking, TIPS don’t have robust returns that I would want to see for an overall answer to inflation in a portfolio,” Schudel says. “You would need some other asset classes as well.”
TIPS are issued at either five-, 10- or 30-year terms. At maturity, investors either receive the adjusted principal or the original principal. If you choose to sell TIPS before they mature, there is a possibility that you could get back less than what you initially invested.
If you want to diversify your portfolio to account for inflation during an inflationary environment, TIPS can yield more than conventional bonds. You can buy TIPS through the Treasury website or your brokerage.
Commodities are another suitable hedge against inflation. These are raw materials including oil, natural gas, precious metals, wheat and corn. They can be traded on the futures market where commodities futures contracts are bought and sold at a certain time in the future.
Commodities naturally protect against inflation. As inflationary pressures prop up prices, commodity prices will subsequently increase as well, and investors can get a good return on those investments.
“Prices will typically move in line with increasing inflation, so the person that invests in them will enjoy the growth that will be in line with the increasing costs of goods and services,” Schudel says.
Given that there is some volatility tied to the commodities market, experts recommend investing in commodities through a diversified investment vehicle such as a mutual fund or exchange-traded fund.
Gold has historically been a popular commodity for protecting your investment portfolio against inflation. Since gold prices coincide with inflation, by investing in gold, you have a better chance of strengthening your purchasing power on potential investment returns.
Even though owning physical gold is preferable, Schudel says, it can be difficult to purchase due to its higher barrier of entry. But, he says, gold ETFs provide an easier way to access gold.
He says finding a quality gold ETF with a track record is a good place to start.
When thinking about how much to allocate toward commodities in your portfolio, Yung says, “Investors need to consider diversifying because we don’t know year to year which particular commodity is going to outperform.”
It’s all about how the investments work together, Yung says.
Typically, depending on investors’ risk tolerance, they don’t want to overweight any particular asset class, Yung says. “Perhaps (for) someone who is more conservative, 5% may make sense,” she says. “(For) someone who may be more aggressive, we would go up from there.”
There are many advantages to investing in real estate. This asset class has intrinsic value, provides consistent income through dividends and is a natural inflation protector.
Real estate can keep up with inflation because of the necessity surrounding it, Schudel says. People will always need to live in homes or apartments, which is why those who invest in this asset class can keep up with inflation.
“Everyone still uses real estate regardless of what the economy and markets are doing. And while they might recede in returns, overall (real estate is) going to be more stable and a pretty quick recoverer when things start to get better, generally speaking,” Schudel says.
Similar to commodities, the value of real estate increases with inflation. For example, if the prices of raw materials to build a home or property increase, the value of that property will increase. “Hard assets naturally hedge (against inflation) because you’re holding an asset that appreciates (at) the same rate as inflation,” Yung says.
Because real estate is a tangible asset, however, it’s illiquid. As an alternative, you may want to consider real estate investment trusts, or REITs, which are more liquid investments that can be bought and sold easily in the markets. In many cases, you can buy a bundle of REITs in either a mutual fund or ETF.
“Investors should possibly consider assets that will pay an income stream,” Yung says. This is another benefit that real estate investments can offer if inflation rises because tenants still need to pay rent.
But when you are sector-specific, Yung says, there’s more risk involved, so an allocation range of 5% to 10% could be suitable — or more or less depending on the client’s risk tolerance, she says.
Despite the persistent fears of rising inflation, there are ways to safeguard your investments. Having one or more of these asset classes comes with a wide range of benefits including protecting your long-term purchasing power. Depending on the degree of inflation, you or your investment professional can adjust your strategy to accommodate.
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