Consumers around the world are all too familiar with inflation by now.
More than two years into the pandemic, companies are contending with supply chain disruptions, which are affecting manufacturing and production timelines and costs. The Russia-Ukraine war has been a contributing factor, driving food and gas prices higher, and will continue to put pressure on the cost of goods and services as long as consumer demand persists.
The headline inflation reading for March peaked at an annual rate of 8.5%, the largest 12-month increase in more than four decades. High inflation is also expected be a headwind for economic growth.
With inflation expected to stay elevated throughout the year, the Federal Reserve is taking a more aggressive stance to tighten monetary policy by moving to increase interest rates and tame the sustained rise in prices.
Investors should address inflation’s effects on their portfolios because if they don’t, it can erode their purchasing power and cut into their returns.
“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. To minimize the impact, consider investments that directly or indirectly benefit from it. Yung says investors must “build portfolios that outpace inflation.”
Here are some effective asset classes that can help with that:
— 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 bonds whose principal rises (and falls) along with consumer prices. They pay interest twice a year at a fixed rate, which is applied to the adjusted principal. Because they are applied to the adjusted principal, the interest payments also 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 buying if the return on investments minus inflation yields a positive return.
Even though TIPS are a well-known inflation hedge, because their yields are so low, they may not be as appealing as some alternatives. The solution: You don’t have to choose just one inflation hedge; you can diversify the inflation-protected securities in your portfolio.
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 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 from your brokerage.
One 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. “Historically speaking, TIPS don’t have the 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.”
Here’s where commodities, another well-known hedge against inflation, come in. 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. You can also purchase commodity exchange-traded funds or commodity stocks.
In fact, commodities act as a natural hedge against inflation. As commodity prices increase to help drive inflation in consumer goods, commodity investors can get a good return on those investments.
“Commodity price inflation has contributed significantly to the inflationary pressures of the last year. As such, in the current inflationary environment, commodity exposure helps provide inflation protection while diversifying the impact of inflation on one’s portfolio,” says Michelle Cluver, portfolio strategist at Global X.
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 tend to 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.
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.”
Among the many advantages to investing in real estate, one of them is protecting your money against inflation. 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 it is a necessity for everyday life, Schudel says. People will always need to live in homes or apartments, and many businesses still want a physical location.
“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 tends to increase even more in an inflationary environment. “Hard assets naturally hedge (against inflation) because you’re holding an asset that appreciates (at) the same rate as inflation,” Yung says.
Real estate is a tangible asset, but 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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Update 05/03/22: This story was published at an earlier date and has been updated with new information.