If you’ve been paying any attention to the news in the summer of 2022, you know that inflation in the United States is at its highest level in four decades. You’ve likely felt the pinch of higher prices when buying gas and shopping for groceries. Your dollars aren’t stretching as far as they did a year ago.
At Addition Financial, we’ve been hearing (and talking) a lot about rising inflation and its impact on our members’ personal finance. One of the things we’re getting asked a lot is about investing for inflation. What can you do to keep your money growing when its buying power is shrinking?
With that in mind, here’s some information about what inflation means for investors and seven factors to keep in mind when investing for inflation.
What Does Inflation Mean for Investors?
Inflation is an economic term that refers to an increase in the Consumer Price Index (CPI), a measurement that refers to the average price of an array of products and services, including rent and mortgage payments, utilities, gas, transportation and groceries. A normal rate of inflation may range from 1.5% to 4%. In a normal year, the Federal Reserve assumes a 2% rate of inflation as a benchmark.
Not all inflation is bad. Rising prices within the normal range are an indicator of economic growth. Inflation is used as a barometer when the IRS sets limits for contributions to retirement plans and for a variety of other economic decisions.
High inflation is another matter. When inflation is above 4%, it signifies that prices are rising faster than wages. High inflation may be caused by a reduced supply of consumer goods due to rising production costs, as is the case in 2022.
Inflation in the US hit a four-decade high in June of 2022, coming in at 9.1%. The numbers for July are a little better but still far above normal at 8.5%.
In terms of what high inflation means for investors, it may mean that their investments are stagnating – not growing as fast as inflation and therefore losing value. Rising prices may put some stocks out of reach for investors as well.
How Does Inflation Affect Investment Returns?
There are two key things you should know about how inflation may affect your investment returns.
It May Erode the Value of an Investment
When inflation is high, it decreases the purchasing power of every dollar you have. For example, if the price of a gallon of milk increases 20% in a year, then at the end of that period your dollar buys 20% less milk than it did at the beginning of the year.
Said another way, the inflation rate represents an erosion in the real value of any investments you make. If you spend $50 on a share of stock and inflation is at 10%, the value of that stock decreases because the purchasing power of your $50 has decreased. The subsequent loss in purchasing power means that your money is worth less than it was when you made the investment.
It Increases the Return You’ll Need to Maintain Your Standard of Living
The second key way that inflation can impact your investments is that you’ll need to get a higher return on your investment to maintain your standard of living.
For example, in a period where inflation is 2% – well within the normal range – you would only need a 2% return on your investment to break even. Anything over that amount would represent growth and an opportunity for you to either improve your standard of living or build a nest egg for retirement.
When inflation is high, the money you put into your investments is less likely to reach the break-even point because prices are increasing quickly. With inflation at 8%, you would need to earn a minimum 8% return on your investment to maintain your standard of living and more than that to improve it.
7 Factors to Help You Invest for Inflation
Here are seven factors to keep in mind when you make the best investment decisions during a period of high inflation.
#1: Diversify Your Portfolio
The first factor to remember is the importance of investment portfolio diversification. Inflation may drive the stock market up but it’s important to be sure that no single stock is responsible for more than 10% of your portfolio.
An ideal diversified portfolio for inflation is one that’s split 60/40 between stocks and bonds. Stocks tend to increase by about 10% per year, which – provided inflation is below 10% – can be a good hedge and a way to protect your money.
#2: Choose Investments Indexed to Inflation
The second thing to consider is whether your portfolio includes investments that are indexed to inflation. What we mean by that is that some investments increase in value during inflationary periods, making them a wise choice if you want to protect your money against inflation.
One example of an inflation-indexed bond are Treasury Inflation-Protected Securities, or TIPS for short. During times of high inflation, the face or par value of these bonds increases to keep pace with inflation. Said another way, you won’t lose money if you buy TIPS because their value will increase with inflation.
We should note that fluctuating interest rates may also impact the value of TIPS and other inflation-indexed investments, so they’re not a good hedge against deflation.
#3: Take Advantage of the Rising Price of Commodities
You already know that inflation reflects an increase in the cost of the Consumer Price Index, meaning that the cost of an array of commodities gets higher.
When it comes to investing, the increase in the cost of commodities can be a good thing. If you invest in commodities such as precious metals, natural gas and grains, your investment will increase in value as the prices of those commodities rise.
#4: Invest in Real Estate
You may be tempted to invest in real estate as a hedge against inflation but it’s important to recognize some of the challenges of doing so.
Real estate is illiquid. If you need cash, you won’t be able to get it immediately if you put your money in real estate. That may make real estate a less-than-ideal investment for inflation.
A better option is to choose a Real Estate Investment Trust (REIT) or a mutual fund that invests in real estate. In either case, you’ll have more liquidity than you would if you bought real estate. An REIT ETF (exchange traded fund) can offer the benefit of diversifying your real estate investment.
#5: Be Careful with Cryptocurrency
Cryptocurrencies such as Bitcoin and Ether have long been touted as hedges against inflation because of their limited supply. For that reason, it’s natural to wonder if adding cryptocurrency to your portfolio is a good idea.
Our advice would be to be extremely cautious about adding cryptocurrency to your investment portfolio. There has been a lot of long-term growth for Bitcoin, which is the oldest cryptocurrency and the most stable, but we’d be remiss if we didn’t point out that even Bitcoin has been highly volatile in 2022.
Even so-called stablecoins, which are supposed to have less volatility because they’re tied to the US dollar, have had a rough go of it. An example is Tether, which lost $1.6 billion in value in just 48 hours.
#6: Remember the Value of Consumer Staples
In periods of high inflation, you can take advantage of rising prices by putting your money into consumer staples. Examples include fuel and food, both of which are necessities that consumers will continue to buy as prices escalate.
Contrast an investment in consumer staples with one in a luxury or cutting-edge product. While these might be worthwhile investments when inflation is normal, it’s likely that sales (and profits) will drop as consumers cut back on discretionary spending due to high prices. That’s not the case with staples, which we all need and will continue to buy.
#7: Keep Enough Cash on Hand
While it may be helpful to invest your money, particularly in inflation-indexed bonds and other investments that tend to outperform inflation, we also believe that it’s important to have enough cash on hand to cover your essential expenses if the unforeseen should occur.
As a rule, we suggest having enough emergency savings to pay for six months of expenses, including the following:
- Rent or mortgage
- Utilities
- Insurance
- Groceries and personal items
- Transportation
- Taxes
In an inflationary period, you should review your savings and recalculate your expenses based on current prices. If you created your emergency fund years ago you may not have enough set aside to cover you if you lose your job or take a pay cut.
Inflation may be high in 2022 but that doesn’t mean you shouldn’t invest your money and do what you can to hedge against inflation when choosing investments. The seven factors we’ve listed here will help you review your portfolio, select investments that can earn money even in the face of high inflation and come out on the other side with a strong portfolio and a promising financial future.
Are you looking for investment advice to help you hedge against inflation and protect your money? Addition Financial is here to help! Click here to read about our MEMBERS Financial Services program and schedule an appointment with one of our Financial Professionals today.
Posted on Sep 1, 2022
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