Investing for Inflation

Ideas to Protect Against Inflation

One of the things I noticed on my trip last week was, that after returning to the city where I hadn’t been in about a year, inflation seemed rampant.  Lunch at the deli downstairs from the office was about $15, last year I thought it was about $12.  Public transportation costs were up by 20% from a year ago, and taxis seemed downright expensive.  Given the scarcity of bonuses or pay raises, inflation has the risk of quickly eroding purchasing power and the real value of cash.

With the US government aggressively trying to stimulate the economy after the shutdown, it seems we are setting ourselves up for a bout of inflation, perhaps more serious than we’ve seen in the recent past.  From an investment cycle perspective, it seems that now is the perfect time to scale into investments that will perform well over the next several years in an inflationary environment.  With the news full of doom and gloom and reports of companies scaling back, this is precisely the time when one should consider investing more.

These are the assets that I’m looking at, with a 5-year horizon in mind (this is not financial advice, only opinion):

Growth stocks

Growth stocks tend to be good inflation hedges as the aggressive growth rates tend to run ahead of the general market.  I’m looking at technology and consumer cyclicals.

Non-US$ investments

Given the aggressive stimulus coming from the US government relative to the European governments, there’s a real chance that the US dollar could weaken significantly in the next couple of years.  I had scaled back my investments in non-$ funds and ETFs and may look to shift in the other direction soon.

Inflation-indexed Treasuries or TIPS

Bonds usually perform poorly during bouts of inflation.  Not only do nominal interest rates rise, but inflation eats into the real value of the fixed cash flows.  Fortunately, the US Treasury issues TIPS where the bond repayment is indexed to inflation.  Look for TIP mutual funds to have a diversified pool of securities

Of course, in regular business cycles, real estate tends to be a good investment during inflation.  Unfortunately for most home owners, the got in during the frothy part of the real-estate bubble.  I am still expecting that real estate still has some correction to go, so this particular business cycle may be quite unique.

Bitcoin & Crypto

In theory, bitcoin could be a good inflation hedge. Assets that investors seek in times of rising prices, such as precious metals and real estate, are scarce or move in the opposite direction of paper money or financial assets. Bitcoin seems to be an excellent choice. Bitcoin supporters also argue that the cryptocurrency will continue to be popular among investors who see it as a store of value during times of inflation, similar to gold.

Long-term investments imply that you will have to wait a longer period of time to reap the benefits of your investment. Patience is therefore essential in this situation. Novice traders are known to rush things on occasion, so don’t let that happen to you. The more patient, calm, and collected you are, the clearer your thoughts will be. This increases your chances of making money.

The Money Illusion

One of the major questions in peoples minds, has to be, what is the harm in a bit of inflation.  After all, when prices are constantly rising, people feel more motivated to put their capital to good use.  In addition, having pay raises usually makes people feel better.  But, this is the problem, especially in the United States. While nominal wages have (mostly) risen, real wages for many workers have not kept pace with inflation. This is referred to as the money illusion. In other words, because your paychecks are getting bigger over time, you think of it as a raise or an increase in the cost of living. Indeed, if the cost of living exceeds your raises, you have effectively become poorer, or your salary has lost real value.

To demonstrate this from a financial standpoint. Assume you have $100,000 in savings today but want to wait until retirement to spend it. If you decide to put your savings under a mattress (earning no interest or dividends), your $100,000 will be worth about $48k in 25 years at a 3% inflation rate. But suppose inflation increased to 5% per year, which was not uncommon a decade ago. In this scenario, your $100,000 should be viewed as less than $30, 000 in 25 years. And, if we end up with double-digit inflation of 10%, the $100,000 adjusted for purchasing power looks like a measly $9230 in today’s dollars.

Not many people are expecting a shift to a very high inflation rate, like 10%.  However, a lot of people have pensions, annuities, or other fixed payments that are not adjusted to inflation.  For those investments, it is important to consider the declining purchasing power that your savings will have over time.  The recent stock market declines appear to have made a number of people more cautious.  Unfortunately, this means that a number of investors who become conservative due to the downturn are at risk of seeing inflation eat away at the purchasing power of their savings.  Next week, I’ll examine investments that have historically kept up with inflation.

Inflation Impact

After running through a number of calculations on the impact on inflation a couple of years ago, my first reaction was that of a sinking feeling in the pit of my stomach type of panic.  I became increasingly concerned that a number of investments that I have, selected for asset allocation reasons, might not offer proper protection against future inflation.  I then reworked my savings plan, recalculated future dividend streams and shifted some assets on the margin. If you are contemplating retiring at a relatively young age, I would recommend analyzing your plans to see if a) you’ve incorporated a realistic inflation rate for expenses; and b) that your investments will perform reasonably in an inflationary environment.  I made the following adjustments:

I recalculated a long-term expected revenue and expenses to include a slightly higher rate of inflation on the expenses.

I have placed limits on investments that were not keeping up with inflation rates (this includes limiting funds in bank CDs that tend to trail actual inflation rates).  This limit forced me to put more money into higher risk assets in Q4 08 and Q1 of this year which was not easy when the first instinct is to squirrel $$ away into the safest possible alternative to a mattress.

I cancelled plans to purchase a fixed annuity, (this was immediately after the sinking feeling) which initially seemed attractive given the rate and partial tax shield. Instead, I placed the funds into a balanced fund that is geared to grow at about 3-4% above the inflation rate.

Also, I continue to maintain investment exposure to assets that should perform well in inflationary environments including ETFs in emerging market stocks and commodities.

While I have found the overall experience of the past year as a period of personal growth, I do still worry that we may be entering into a period of protracted global inflation with price rises similar to the ones we experienced in the past with respect to food and energy prices. And while I do think that being frugal is great, there are limits to how much can be saved. But, I feel better having spent some time thinking about the issue and taking some portfolio actions.

Please note: This content is provided for informational purposes only; it should not be construed as legal, tax, investment, financial, or other advice. 

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