Hedging Against Rising Inflation
With the latest annualized inflation rate in the United States eclipsing 8%, worry of how rising inflation will affect personal finances only continues to grow across the country. Talk of rising inflation is everywhere; it is no wonder there is a lot of questions surrounding the topic of inflation.
Will inflation get worse? When will inflation slow down? These are just a couple of the questions that come to mind, but there is one question everyone should be asking. How do I protect my money from inflation?
Inflation is inevitable. Without fail, over time, the purchasing power of the dollar will continue to decrease. So, how do you protect your money from inflation?
Below are a few ways you can protect your hard-earned money and investment portfolio from the effects of inflation.
Cash is Not Always King
The balance in your bank account earning less than 0.5% interest is not doing you any favors. In fact, holding cash is a surefire way to lose against inflation. In the United States we have experienced an average inflation rate of between 2% and 4% over the last 50 years. This means that in order to maintain value, you need at least a 4% return on your investment. It is virtually impossible to find a standard bank account that is paying an interest rate of 4%.
This isn’t to say that CD’s, Money Market accounts, and cash don’t have their place in a holistic financial plan, but rather to say that to beat rising inflation and save for retirement your money must be invested to outpace inflation and save for the future. But where should you allocate your well-earned money instead?
Globally Diversified Stock Portfolio
While inflation in the United States is at a 40-year high, the same cannot be said for the rest of the world. The UK is seeing slightly lower inflation of 7.8% while China and Japan are only seeing 1.5% and 2% respectively. The point being inflation does not affect every part of the world in the same way at the same time. Owning stock in companies is a way to hedge against inflation on its own. The companies that you are purchasing stock in are the same companies that are selling the inflated goods. The consumer is the one really facing the consequences of inflation, so it is better to be an owner who benefits from the inflated prices. Thus, having a globally diversified stock portfolio can be advantageous in protecting your portfolio from inflation.
Tilt Towards Small Cap Value Companies
Small Cap Value stocks tend to perform well in an inflationary environment. In fact, their average inflation adjusted return during years with above median inflation from 1927 to 2020 is around 12%. Compare that to only about 5% from Large Cap Growth stocks during the same period and you see a 7% premium from owning Small Value companies. This is one of the reasons why, at HFG Trust, we have tilted our portfolio towards Small Cap Value stocks. Also, despite markets sliding this year, we have seen Small Cap Value stocks out-perform Large Cap Growth stocks. Small Cap Value stocks are only down 12.35% YTD compared to Large Cap Growth being down more than 27%; granted, this is not only because of inflation.
Fixed Income Strategies
Most people do not build their portfolio solely on equities. So, how do you hedge against inflation in the fixed income portion of your portfolio? One way to do so is by investing in Inflation-Protected Bonds. These bonds can be a great way to safeguard your fixed income investments from inflation. In a period of higher-than-expected inflation, these bonds payout at an inflation-adjusted principal or the original principal, whichever is higher.
Series I Bonds
Series I Bonds, or I bonds, can be a protective tool in inflationary environments, as well. I bonds are US Treasury issued bonds. Their sole intention is to pay an interest rate that keeps pace with inflation. Rates are set twice a year, and they change for the bond holder every six months. Currently, I bonds are paying around a 9.62% interest rate. Because these rates move with inflation, they can be a useful tool to combat it.
There are a few things to consider when purchasing I bonds. Only $10,000 worth of electronic I bonds can be purchased per person per year and $5,000 a year of paper bonds. The bonds must be held for at least one year before cashing them, and if you cash them before five years then you lose the prior 3 months of interest. You can apply for physical I bonds when you file your federal tax return, and you can purchase electronic I bonds online by clicking here.
Owning Real Estate
Home prices have kept pace with or outperformed inflation. Owning physical assets, like a home, can serve as a useful tool in protecting your money from inflation. There are also private real estate funds that commonly make good returns during high inflation. As an added bonus, private real estate is not directly correlated to the stock market or inflation. This means that it can act as an alternative investment in your portfolio.
There is no denying the impact inflation has had on people across the United States this year. This is not the first time inflation has spiked, and it certainly will not be the last. With standard inflation hovering around 2% to 3%, it is always important to have safeguards against inflation in your portfolio. It is even more important now, to keep pace with the high inflation we are experiencing today.
No one wants to watch their purchasing power erode month after month and year after year. It is impossible to save for retirement if you aren’t keeping pace with inflation. Next time you meet with your financial advisor to discuss your financial situation, make sure to bring up how you plan to combat rising inflation and consider using some of the provided points to your advantage. As always, if you should have any further questions, please contact an advisor at HFG Trust.