Ever find yourself wondering: as an Individual, how do I hedge against inflation? Is there a best way to hedge against inflation? How do assets like Gold and Bitcoin work as a hedge? This post will cover some essential knowledge about Inflation, how to get started, and assets you can use to protect your portfolio.
What is Inflation, and What should I do about it with an Inflation Hedge?
Inflation is an invisible economic force and can be hard to notice without paying special attention. In a sentence, inflation keeps your dollars from buying as much as they once did due to rising costs. While a little inflation is typically a sign of a healthy economy, rampant inflation can be hazardous. (Incidentally, the opposite effect is deflation, where broad prices decrease over time).
Fundamentals of Inflation, and How to Hedge Your Portfolio against Inflation
Let us dive-in and start with some ground work. With this in hand, we can better understand our situation and how to more effectively deal with the effects of inflation.
What is Inflation? Meaning, and Understanding Inflation Risk
Inflation is the broad (think in terms of the economy) increase of prices over time. In general terms, inflation promotes spending your dollars today because they will be worth less tomorrow. Small amounts of inflation in the economy can be a good sign. However, there is a certain amount of risk to your portfolio – especially one that is largely made up of cash.
Is Inflation Good or Bad?
In an economic context, a little inflation is usually considered a good thing (all things equal) and could indicate that the economy is growing, getting stronger, and is otherwise healthy. With a little inflation (e.g. the standard 2% target), the idea is that it promotes consumer spending and a stable economy.
It becomes “bad” when it spikes and drives prices too high too quickly. In order to moderate or prevent this surge, the Fed can weigh-in with tools it has to control inflation before it gets to be a disaster. However, keep in mind the Fed will do what the Fed will do for the economy as a whole, and what is “good” for the economy can be different depending on the individual(s) in charge.
What does Inflation do to my Portfolio?
Especially over time, inflation (and taxes) can dampen the nominal return of an investment or portfolio. The Real Return on investments is a better way to think about money, and it helps underscore the importance of Mêtis in your portfolio management. Taking steps to hedge against inflation can help strengthen your portfolio and support your real return over time.
What does Inflation do to the Value of the Dollar?
Higher inflation means the dollar is losing purchasing power. Because of this, it translates into the idea that spending today is better than saving for tomorrow (when prices will be higher and you cannot purchase as much as today). Keep in mind, this is just talking about saving dollars (not Savings as a concept).
What drives Inflation? How is it measured?
With these essentials in mind, let’s take a closer look at some of the technical pieces and meet some of the big players.
Who or What Controls Inflation?
Enter the Federal Reserve. In a term, think of “Monetary policy” as one of the ways to manage and control inflation. They routinely monitor and track this over time. In a broad sense, they strive to achieve the congressional “dual mandate” of maximum employment and stable prices. To achieve these mandates, the FOMC (Federal Open Market Committee, still part of the Federal Reserve) which is focused on monetary policy, has stated that an average 2% annual inflation is ideal.
At a high level, Contractionary Monetary policy is used to slow or decrease inflation. Historically, some common tools to combat inflation have been increased interest rates, increase reserve requirements, and reduce the supply of money.
Remember, the Fed’s monetary policy (i.e. the actions of central banks) is different from the government’s fiscal policy (set by the Congress, and Administration). As such, the Federal Reserve was set up to act as an independent agency.
How is inflation tracked?
Common Indexes include the CPI, PPI, PCE Price Index. The Federal Open Market Committee (FOMC) uses all three and more to track the “general increase in the overall price level of the goods and services in the economy.”
The Consumer Price Index (CPI) famously measures a “basket of goods” to calculate the rate of inflation. According to the U.S. Bureau of Labor Statistics (BLS), the basket consists of “food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services.” This data is collected from “75 urban areas throughout the country and from about 23,000 retail and service establishments.”
On the other side is the Producer Price Index (PPI) which is used to “capture price movement prior to the retail level.” Like the CPI, it is used as another reference point for governmental fiscal and monetary policies. Different from the CPI (a buyer’s perspective), the PPI tracks “price change from the perspective of the seller.” This index is also maintained by the BLS.
Another helpful indicator is the Personal Consumption Expenditures Price Index (PCE) as provided by the Bureau of Economic Analysis (BEA). The PCE Price Index “reflects changes in the prices of goods and services” and “is known for capturing inflation (or deflation) across a wide range of consumer expenses and for reflecting changes in consumer behavior.” This can be helpful for understanding the macroeconomic picture a little better. Personally, I like to look at this one and the CPI.
Aside from the notes already mentioned, some fundamental differences across these 3 include the focus and overall approach in terms of formula construction and methodologies. Think of it as a different perspective or view on the topic.
Curious about the actual numbers? Start with these two calculators!
Looking for some charts and graphs to track inflation? Take a look at the Federal Reserve Bank of St. Louis, where you can see CPI for all Urban consumers since 1947. There are many other helpful resources on their site as well.
How to Hedge against inflation as an Individual
Assuming the target inflation average of 2%, what can individuals do? Remember, the Fed states it is primarily concerned with the long-term state of the economy. However, individuals must take action to cultivate Mêtis in their money matters, protect their portfolios, and invest accordingly. As with all financial decisions, be sure to consult with your trusted financial advisor.
How to Hedge against Inflation in Retirement
Imagine: you’ve worked hard your whole life to shore-up a nice retirement only to realize your principal has been steadily eaten away by an estimated 2% compounded annually (a conservative estimate). Since you can’t “see it” as a line-item on your statement it might be harder to track as well. But, the damage has been done this whole time. Not to “pile it on” too much, but one should also keep the tax burden in mind as well. Below, I’ve listed some focus points to use as you evaluate your retirement strategy.
Inflation and Social Security
On a positive point, Social Security benefits contain a cost of living adjustment (COLA). This effectively scales your benefits depending on the level of inflation and in accordance with formulas established in the Social Security Act. In general, my personal strategy will be to delay drawing benefits as long as possible. Consult with your advisor to see what works best for you and your family.
Can Inflation impact your 401(K), IRA or ROTH IRA?
As we have established earlier, inflation is measured and tracked broadly and over time. It can impact your 401(K) just as anything else, and without careful attention, it can chip away at your savings in the same manner. As I said earlier, taxes are also an important factor to keep in mind. On a side-note, my personal preference is toward Roth instruments: I prefer to pay those taxes now instead of later.
Should I hold Cash?
In my opinion, be especially careful of holding large amounts of cash long term. With respect to inflation in general, (and especially over time) the purchasing power of the dollar will decrease. It is important to keep up with inflation so that you can at least keep up with the cost of living. Personally, I hold a minimum cash balance in the form of an emergency fund. Otherwise, I try to put my dollars to work making more dollars!
What is the best Hedge against Inflation? Investment Options to Consider
Here are a few ideas on places you can start hedging your portfolio against inflation. I recommend you take a look at your portfolio overall and consider your strategy in light of the “big picture.” With this approach, instead of just looking at your individual accounts (for example), you develop a more robust strategy. As with any investment, consider the opportunity cost of owning that investment, have a strategy/ plan, and as always, consult with your trusted advisor.
REITs (Real Estate Investment Trusts) as an effective way to Hedge Inflation
REITs are a great way to get exposure to real estate, such as commercial properties, without owning the properties directly. Generally speaking, they are companies that own and manage real estate. REITs also cover multiple sectors such as commercial retail, office, telecommunications, and housing just to name a few.
Looking for a few suggestions? According to Kiplinger, check out Vanguard’s Index Funds Real Estate ETF (VNQ) for broad exposure. In addition, American Tower (AMT), or W.P. Carey (WPC) are examples of sector-specific REITs. There are several options and investors should be careful to do their homework before transacting.
TIPS (Treasury Inflation Protected Securities)
TIPS are categorized under US Treasuries, are issued by the U.S. Department of the Treasury, pay interest every 6 months, and have maturities ranging from 5 to 30 years. More specifically, the principal changes, and effectively updates based on underlying changes in the CPI (moves with inflation and deflation). It could help preserve your portfolio’s Real value with this feature.
However, there are risks with TIPS (as with any investment), and one should be careful to understand how these best fit in their overall portfolio. TIPS generally offer a comparatively low yield in relation to other asset classes.
Can you Hedge against Inflation with Bitcoin?
There is also interesting and compelling research surrounding the use of Bitcoin to preserve value. Here, you’ll find my review of one of my favorite books on the matter. Bitcoin exists within a free-market and there are comparatively large swings and volatility. Proponents would argue this is not a reason to stay out of Bitcoin.
There is certainly a lot of back-and-forth about whether or not it is a good investment. On one side, there are those who argue it is a hedge against inflation and the government (it can’t be devalued), as well as being a store of wealth.
On the other hand, naysayers argue that Bitcoin has been accused of not holding intrinsic value, and is subject to the whims of speculative investors. I’ll leave you to be the judge of what works best for your portfolio.
Are Stocks a Hedge against Inflation?
Stocks, especially those of companies well positioned to deal with increasing prices, could be a great addition to your inflation hedge.
Think about what essentials are going to be needed, even In an inflationary environment when prices are increasing. You could also consider a broader approach by investing in the S&P 500. Warren Buffett is famous for recommending low-cost index investing, and I think this a great idea for those who are looking broadly to diversify.
Precious Metals: Silver and Gold
Last, but not least, let’s take a look at Silver and Gold together. These precious metals have long been heralded as a safe-haven against the storms of inflation. Here are some thoughts on the two – take a look and see if these could serve your interests well.
Is Silver a good Hedge Against Inflation?
Silver, and really all precious metals, are debated as to their efficacy as an investment and as an inflation hedge. I see several factors contributing to silver’s value and it is for that reason I like the metal.
I agree with “the bottom line” in Forbes, saying of silver “if only to diversify your wealth further in this extremely volatile times, precious metals are a must.” Others will say that silver is not worth the long-term opportunity cost to own and hold.
If you’re not interested in buying physical silver, consider ETFs like (SLV) or other low-cost funds to get exposure to the metal. Buying stocks in silver mining companies could also help achieve exposure as well.
What is the relationship between Inflation and Gold?
I remember when I first purchased a gram of gold as a youngster. I was in my early teens, and don’t remember what I paid, but I do remember the feeling of owning my own gold. It was empowering!
At the time, and still today, gold is often presented as a logical hedge against inflation. However, the reality is that holding precious metals can be costly (especially at higher quantities where security becomes a factor). Additionally, there are no “dividend” payments from gold.
The effect of holding gold can also be achieved through purchasing gold mining stocks, or precious metals ETFs like (GLD) or mutual funds, which will give you the exposure without forcing you to hold the asset. I think gold works best for the very long-term play as a store of value against inflation.
Inflation impacts us all. I hope this post serves you well, raises awareness, and suggests some action items that we can all use to hedge our portfolios. I wish you the best of luck on your financial journey. Keep the course – keep cultivating and growing Mêtis in your Money Matters, my friend!
Here are a few more posts that might interest you:
- Practical Guide & FAQ to the Health Savings Account (HSA)
- Saving for Retirement
- Indexed Universal Life Insurance Policies: Are They Good or Bad?
- Leaving an Inheritance for Your Children
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