Minimize Inflation Risk In Your Portfolio
Inflation now has a seat at most dinner tables, is shared chatter on the street, has become a headliner on the economic stage, and has wiggled its way into the minds of most consumers and investors. It announces itself everywhere via increasing oil prices, lumber prices, steel prices, real estate and more. The consensus of most economists is that some inflation is needed and can help the economy if it is kept at a consistent and appropriate level. The Federal Reserve even strives for a two percent inflation rate, which tends to be a ripe environment for maximum employment and price stability. Problems arise when inflation gets too high. People struggle to buy goods and services. What happened to cause inflation to go up? Low interest rates set by the Federal Reserve, several rounds of direct government stimulus to consumers and businesses (30 percent increase in the money supply), and the release of pent-up consumer demand has all led to demand outpacing supply leading to shortages and a surge in prices (aka inflation). So, what can you do to combat inflation?
Limit Your Position in Long-Term Bonds
Due to being fixed-income investments, bonds are susceptible to inflationary risk. When the purchasing power of the dollar declines, so does your bond income. You’ll still receive the same amount of money with each payment, but those payments won’t buy as many things. So, if you buy a long – term bond, such as a 30-year, that pays a 4 percent interest rate, and inflation shoots up to 10 percent or higher, you are losing purchasing power every single year. If you purchase a shorter-term bond, your inflationary risk is limited to however much inflation can occur in those few months.
Consider Treasury inflation-protected securities (TIPS)
During inflationary periods, they pay out more in interest and increase in value. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal, so interest payments rise with inflation and fall with deflation. In high-inflation environments, TIPS performance may exceed that of traditional government bonds, whose fixed interest payments effectively become smaller over time. This combined with the fact that they are backed by the U.S. government, makes them very attractive to conservative or income-focused investors.
Consider Alternative Assets
These are real assets that have intrinsic value to collectors. Anything from fine art to baseball cards to fine wines. Their prices may be unpredictable, but the value of these investments is expected to appreciate over time, providing returns that exceed the inflation rate. They tend to have lower volatility than their more traditional peers because the same market forces that impact stocks and bonds don’t correlate as much to this asset class.
Most financial advisors recommend that alternative investments make up no more than 5-10% of any portfolio, according to a survey co-sponsored by the Financial Planning Association.
Invest in Sectors Conducive to an Inflationary Environment
Energy, financials, industrials, materials, or companies that provide commodity-related materials to other businesses (for example steel or chemical suppliers) all tend to do well when inflation is rising. Technology is also an area that has potential to do well during times of inflation because their business models may be less vulnerable to pricing and supply chain disruptions. Adding or increasing your position in funds, ETFs or stocks within these sectors could help you gain some ground during times of inflation.
Consider Commodities
Commodities are another popular hedge against inflation. These are raw materials including oil, natural gas, precious metals, wheat, and corn. As inflationary pressures boost prices, commodity prices will eventually increase as well, and investors can score a decent return on those investments. For example, gold is widely regarded as an attractive hedge against inflation. Due to its low correlation with other asset classes, it is considered a great diversifier. Typically, when the stock market has a pullback, the price of gold goes up. It retains its value when the dollar declines or loses purchasing power. Purchasing physical gold can be difficult due to its higher barrier of entry, so many investors have turned to gold ETFs or gold mining stocks instead.
Consider Real Estate
Real estate traditionally does well during periods of higher inflation, as the value of property can increase and therefore the rents landlords charge can too. Some investors utilize Real Estate Investment Trusts (REITs) to capitalize on this area. Others may participate through mutual funds that invest in REITs. According to data from Neuberger Berman, over the past 30 years, an index of U.S. real estate investment trusts reflected larger gains than the S&P 500 in five of the six years when inflation was 3% or higher.
See the Big Picture
We are all guilty of being so fixated on performance and returns that we forget to understand how external market/environmental factors such as inflation can impact our overall financial plan. It is crucial that investors take pause to ask important questions like will this loss of purchasing power negatively impact my portfolio? Do I need to realign my investments to generate more income to make up the shortfall? Does my plan factor in inflation? If so, at what level – 2 percent, 3 percent? Speaking with your financial advisor can ensure these questions are answered.
The trap that many investors fall victim to is letting their emotions drive their decisions. Look for opportunities and capitalize on them when it makes sense to do so, be disciplined in managing your risk, and stay focused on your primary investing and financial goals. Remember to take a step back and look at the aerial view of your plan so you understand how each area impacts the other and to ensure the decisions you make today are consistent with the goals and strategies you have set for yourself.
Kiplinger. (July 2021). Shield Your Portfolio from Inflation.
https://www.kiplinger.com/investing/etfs/603178/shield-your-portfolio-from-inflation
Money.US News. (June 2021). 3 Best Investments for Inflation.
https://money.usnews.com/investing/investing-101/articles/best-investments-for-inflation
Kiplinger. (August 2021). 8 Ways to Insulate Yourself from Inflation.
https://www.kiplinger.com/personal-finance/603306/8-ways-to-insulate-yourself-from-inflation
NY Times. (July 2021). How to Manage Your Money if Inflation Flares.
https://www.nytimes.com/2021/07/09/business/money-management-inflation.html
The Balance. (July 2021). How to Mitigate the Threat of Inflation in a Portfolio.
https://www.thebalance.com/inflation-risk-management-strategies-357604
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Main Street Advisors, LLC. August 2021. Main Street Advisors, Inc. is a Registered Investment Advisor. The articles and opinions expressed in this material were gathered from a variety of sources, but are reviewed by Main Street Advisors, LLC, prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of August 2021 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual situation. Always contact your financial/investment professional before making any financial decisions. Main Street Advisors, LLC is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
