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14 April 2022,03:58

Trading Blog

How to Diversify Your Portfolio for Inflation

14 April 2022, 03:58

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While most investors will greet inflation as bad news, moderate, consistent inflation is healthy for the economy, promoting productivity and driving demand and consumption. However, high inflation can also erode the value of cash – often at a much quicker rate than income increases. Other assets, however, can grow with and even outpace inflation.

However, investing to beat inflation is often more complex than putting your money into hedging assets. There are many factors to consider, including the rate of inflation, how long high inflation lasts, and other ongoing political and economic factors.

Assets that perform poorly during inflation

Cash

You might have heard the refrain that cash is a depreciating asset. That’s because inflation is nearly universally persistent. The only time in recent history when the US had experienced deflation was during the Great Depression in 1930 and the economic collapse in 2008.  

While the nominal (meaning unadjusted to account for inflation) value of your cash might not change – $100 will still be $100 in 20 years – your purchasing power will. The same loaf of bread that costs $2 now might cost $5 in 20 years, and that same $100 will only get you 20 loaves instead of the 50 loaves now. 

That said, it is always prudent to have some cash on hand as it is the most liquid asset there is. In addition, interest rates are usually raised in times of high inflation. In the short term, putting your cash in a high-yield savings account can possibly generate enough interest to offset inflation. 

Securities with fixed-rate interest

Assets in this category include bonds, certificates of deposit, and treasury bills. Because the income generated from this category of assets is fixed until the maturation date, the purchasing power of the income declines with inflation. This is also why the price of bonds tends to drop during times of higher inflation. 

Assets that grow with or match inflation

Gold

Gold is considered to be one of the most consistent hedges against inflation. This is because, as a physical asset and one of the oldest stores of value, gold more or less rises in nominal value alongside inflation. Gold becomes especially attractive for countries whose currency is rapidly devaluing. The most recent example of this is the price of gold surging amid high global inflation and the Russian ruble plummeting during the Russian invasion of Ukraine in early 2022. 

While it is a good choice for diversification, gold does not generate returns and is not a particularly good hedge, especially when holding long-term and during times of high interest. 

TIPS

TIPS, or Treasury Inflation-Protected Securities, are a class of US Treasury bonds specifically structured to protect against inflation. These bonds are indexed to inflation and adjust their principal amount based on inflation while paying fixed interest rates. TIPS come in 5, 10 and 30-year maturities, with interest paid every 6 months. However, the interest rates on TIPS are usually lower than those of fixed-rate bonds, presenting an additional risk if the period of increased inflation is short-lived. 

Stocks

Value stocks, or stocks in companies where the performance outmatches the stock price, tend to perform better in high-inflation environments as these companies already have cash flow, and are less adversely affected (or can benefit from) high interest rates

Other stocks to look at include those of companies that can pass on the increasing costs of high inflation to customers, like consumer staples including food and beverages, as well as household products. 

Growth stocks, like those of disruptive or emerging tech, tend to do poorly during high inflation due to reduced estimates of such a company’s projected future earnings. In addition, times of high inflation are usually accompanied by increased interest rates, which also tend to negatively affect growth companies as investors will begin rotating to safer, interest-paying investments like bonds.

A low-cost way to diversify is to invest in an ETF that tracks an index like the S&P 500. With an average return of roughly 9% with dividends reinvested over the past 20 years, the S&P 500 beat out inflation by about 7% on average annually. An S&P 500 ETF or index fund is an easy, low-cost way to diversify a portfolio. 

Real Estate

Just like consumer staples, real estate and rental prices can be shifted alongside increasing inflation. Investors can purchase property, which might require a large amount of capital, or invest in Real Estate Investment Trusts (REITs), which are companies that own and manage a portfolio of income-generating properties including malls, hospitals, and hotels. However, it is important to note that real estate is also vulnerable to the rising interest rates that often accompany inflation. Central banks often increase interest rates to combat inflation, which can cause more defaults on mortgages.

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