Inflation 101 – and Some of the Best Ways to Hedge Against It.

Inflation is currently a major economic concern in many countries since it can lead to the depreciation of the value of money over time. You’ve probably noticed it everywhere – from news headlines to when you’re at the supermarket.  It usually causes an uneven rise in the prices of goods and services, reducing consumer purchasing power. 

Consequently, it becomes impossible to maintain a steady standard of living over time. We wise Stackers recognize this and the utter importance of protecting your Benjamins against the ravages of inflation. Before we dive in, let’s throw it back to Stacking 101: what is inflation? 

Understanding Inflation 

Inflation is the rise in the price of goods and services over time. “Hyperinflation” (extreme inflation) can even make a currency to be essentially worthless. While it may feel like we’re there in today’s current inflationary environment, the worst cases of inflation in US history date back to 1778 during the Revolutionary War (nearly 30%) and just above 20% in 1917 during World War I.  In an inflationary economy, consumers must possess more money just to maintain their current living standards – not to mention actually growing their standards of living. 

Inflation can be caused by the demand-pull effect, cost-push effect, devaluation of currency (intentional or not), increased money supply (“money printer go ‘BRRR’”), and (last, but not least) rising wages. What’s a sage Benjamin Stacker to do? Here are some of the best ways to protect your investment portfolio against inflation.

1. Invest in Appreciating Assets!

Investing in appreciating assets is one of the best ways to protect yourself from inflation. These assets usually increase in value over time. Examples of appreciating assets include our two favorites – stocks and real estate. Once you have the basics covered, you may want to expand into higher risk investments – art and collectibles. Don’t venture into this world of investing unless it only represents a small portion of your overall portfolio. By investing in appreciating assets, you give your money the best chance to recruit more Benjamins into your ever-growing Benjamin army – and thus your finances are not devalued by inflation.

2. Domestic Index Funds

Index funds are a type of mutual fund that invests in a range of stocks and bonds. They are designed to track the components of specified underlying investments in a financial market. 

Investing in an index fund ensures that your money is diversified across different asset classes. This can help protect yourself against inflation, as various asset classes may perform differently in different economic climates.

The most common example of an index fund is one that tracks the S&P 500 Index (Thank you, Saint Jack!). By investing in such a fund, you participate in the economic results of the largest 500 publically traded companies in the United States.

3. Invest in Bonds

No, we’re not paying homage to 007! Bonds are a type of debt instrument that pays out a fixed interest rate over a set period of time. By investing in bonds, you are essentially loaning money to the bond issuer, who agrees to pay you a set rate of return for the duration of that bond (loan). In a rising interest rate environment, the prices of existing bonds tend to fall. Just take a look at 2022’s historic bond decline in the face of a Federal Reserve on a mission to tame inflation. (On the plus side for bond fund investors, the interest rate of your fund will go up along with the overall interest rate environment.) 

You can invest in these four categories of bonds:

• Government bonds: These are issued by the U.S. Treasury. 
• Corporate bonds: These types of bonds are usually issued by companies.
• Agency bonds: They are given out by government-affiliated organizations. 
• Municipal bonds: They are usually issued by states and municipalities. Their dividends are usually tax-exempt but pay a lower rate. Probably most suitable for Stackers in a higher income tax bracket. 

Bonds tend to be an acceptable, less risky, addition to your overall investment portfolio – reducing portfolio volatility in an otherwise all-stock portfolio. Plus, they have the added benefit of proving steady income – particularly helpful for retirees and investors in the drawdown stage of their life. Bond funds generally pay monthly dividends while individual bonds pay every 6 months. If you own an individual bond, however, and hold it to maturity, the issuing entity guarantees you’ll get the full value of the bond ($1,000) back as well as the semi-annual interest you receive along the way. Bond funds, on the other hand, have a variable share price that tends to have an inverse relationship with interest rates, but bond funds are liquid – you can get your money out at any time.

4. Go International

It’s a big world out there, and while the US remains the largest economy, there may be benefits to diversifying your investment portfolio to include stocks of foreign companies. International stocks can also be a great way to protect yourself from inflation. They may perform differently in different economic climates when compared to US stocks. For example, if inflation rises more quickly in the US than globally, international stocks may outperform a totally US-centric stock portfolio. This way, you will have many choices to protect your portfolio in an inflationary environment. Added diversification!

Don’t discount the potential benefit of international bonds, as well. For US-based investors, international bonds tend to perform better than their domestic counterparts when inflation rates abroad are less than here in the US. Similar to US stocks and bonds, international bonds (and international bond funds) tend to be less volatile than international stocks.

5. Have a Savings Account

What? A savings account? While savings accounts will not make serious money, the purpose of having adequate savings is to serve as insurance against an emergency. There’s a reason it’s called an “emergency fund.” By having a healthy cash reserve, you can free yourself up to be more aggressive with the other pieces of your financial portfolio. 

6. Invest in Commodities 

Caution is recommended when considering commodities! Commodities are a type of asset that can be interchangeable with other goods. Usually, the value of companies dealing with commodities rises over time. Examples of commodities include minerals or agricultural products. Commodities are helpful in shielding your portfolio against inflation because their prices tend to rise when inflation increases. 

7. Invest in Derivatives

Like commodities, caution is recommended when considering derivatives! Derivatives are a type of financial instrument that is based on the value of another asset. They can be used to speculate or hedge your investment. Examples of derivatives include futures and options. By investing in derivatives, you can protect yourself from the effects of inflation because their value is not directly linked to the value of the underlying asset. 

8. Get a Fixed-Rate Loan

With fixed-rate loans, the interest rates you pay don’t fluctuate even if inflation rises. Therefore, getting a fixed-rate loan when you borrow money gives you certainty about how much your payments will be for the life of the loan. Your repayment amounts will not be affected by changes in inflation.

Conclusion and takeaways (plus a shameless plug)

Inflation is a serious concern for all of us, but there are ways to protect your money from its effects. By investing in appreciating assets, (index funds, bonds, international stocks, and international bonds), and maybe commodities and derivatives (if you’re adventurous and have your core financial planning bases covered), as well as properly using a savings account and making smart moves when taking on debt (fixed-rate loan), you can ensure that inflation’s effects on your money is minimized as much as possible. As always, do your own research before making any financial moves.

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