What Is Inflation?
Inflation is an increase in the price of commonly used goods and services in an economy. In the United States, this metric is most frequently measured by changes in the Consumer Price Index (CPI), a weighted average of the prices of a hypothetical basket of essential goods and services.
For the 12-month period ending February 28, 2022, the CPI rose a whopping 7.9% — the largest increase reported in over 40 years. If you exclude volatile food and energy products, the increase remains elevated, at 6.4%.
Many factors have contributed to the price increases, including supply chain disruptions caused by COVID-19, surging consumer demand for products and mounting wage pressures across various areas of the economy. In the wake of the war in Ukraine, severe geopolitical stress is fanning the flames. These factors, in combination, pose a significant risk to the average U.S. consumer.
Deflation is the opposite of inflation; it’s an overall decrease in the price of goods and services. On the surface, the concept of deflation sounds good, but it’s a very bad economic situation. Prolonged deflation can lock an economy into a stubborn downward spiral of reduced spending and flagging confidence.
How Can Inflation Affect My Finances?
A moderate and consistent degree of inflation (the historical target is 2%) is generally considered a sign of economic health, but rapid price increases can have a destabilizing effect on an economy and jeopardize your hard-earned savings. The problem is most significant for households with lower income levels and for retirees living on tight budgets.
Over time, the pressures of inflation can diminish the purchasing power of your income, leaving you scrambling to cover rising housing costs, food prices, energy bills and medical expenses. The results can be devastating to your personal finance situation.
What Are Inflation-Protected Assets?
Fortunately, there are ways to protect your finances from the effects of inflation. One way to protect your investment portfolio during a period of inflation is by investing in inflation-protected assets. Such assets have a high probability of generating additional income and increasing in value in the face of rising prices.
In addition, a standard, foundational approach is to maintain a flexible budget, which means you’re able to temporarily decrease your everyday living expenses during challenging times.
Not everyone may be able to do this, but for those who are, the benefits can be immense. By adjusting your lifestyle and decreasing your expenses during hard times, you’ll be better able to ride out financial difficulties, preserve your hard-earned savings, avoid making poorly timed asset sales and gain a sense of financial peace.
Other inflation-protected assets and strategies are outlined below.
High-Yield, Floating-Rate Bank Loans
High-yield bank loans (HYBLs), which are often referred to as leveraged loans, are an effective way to protect your finances from inflation. The protective nature of these loans stems from the fact that their interest rates periodically reset to keep pace with the prevailing market rates, which are strongly correlated with inflation.
The corporations that issue HYBLs have credit ratings below investment grade (also known as non-investment grade), which should give you a reason to pause if you’re a credit-focused investor. However, to secure the loans, the corporations are generally required to pledge that they have adequate collateral to repay the loans. This pledge can help negate any concerns about creditworthiness.
Regardless, it’s important to note that during times of economic distress, assets like HYBLs can demonstrate equity-like volatility. As a result, they experience periods of illiquidity, when the assets are not able to be quickly or easily converted into cash without a loss in value. To minimize your exposure to this risk, be sure to invest in HYBLs via a fund-style vehicle with many individual positions.
Another inflation-protected asset is precious metals such as gold, silver and platinum. Historically, these assets have shown a high degree of resiliency during prolonged periods of inflation. Investing in precious metals can also help diversify your portfolio if it’s comprised mostly of stocks and bonds.
Precious metal investments do have a major drawback, however — they do not yield any income. When interest rates rise, which often happens during periods of inflation to combat the effects, precious metals can significantly underperform financial securities.
Given this conundrum, some fee-based providers of precious metals may encourage you to time the market, moving into and out of precious metals as the landscape shifts. However, this is poor advice and highly discouraged. Timing the market successfully is extremely difficult, and it’s debatable whether anyone has been able to consistently do so.
A more sensible approach is to establish a strategic allocation of precious metals (perhaps 5% to 10%) in your long-term investment strategy. This modest allocation can provide a source of strength during inflationary periods and may improve the overall efficiency of your portfolio (i.e., risk vs. return).
If you want to make ongoing investments in precious metals, you can do it in a few ways. Metals can be purchased directly, but the storage costs can be prohibitive. Alternatively, you can gain exposure indirectly by investing in diversified, metals-focused funds.
Historically, commercial real estate (CRE) has been another effective hedge against inflation. CRE includes any property that is owned and operated for the purpose of generating economic value. This differs from residential real estate, which is used primarily for living space.
Most CRE assets generate income via lease arrangements. These arrangements can include homes, apartment buildings, storage complexes, office buildings, shopping centers and industrial facilities. The ability for CRE investments to protect against inflation stems from the fact that, as inflation rises, so do property values and monthly rents.
The rise in property values and rents enables owners of CRE to maintain the real value of their properties while generating higher incomes over time. Of course, the extent to which this occurs depends on many factors, including the balance of supply and demand in the area around the property.
Investors can buy real estate directly or invest in it indirectly via the shares of real estate investment trusts (REITs) and other specialized funds. Directly investing in real estate can be lucrative and comes with several tax advantages, but the process can cost a lot of money up front and involve significant expenses for transactions and maintenance. Share-based ownership of real estate sidesteps these disadvantages, providing investors a more efficient way to establish a diversified real estate portfolio.
A final inflation-protected asset is the collection of publicly traded equities commonly known as stocks. Essentially, this asset class gives investors the ability to buy a proportional ownership stake in virtually any publicly traded company in the world.
In a general sense, cyclical stocks, which move in tandem with the overall economy, are the most effective at battling inflation. Even stronger are investments in cyclical stocks that also have high growth potential.
The relatively high return potential and pricing power of these types of companies can easily reinforce the real, long-term value of your financial portfolio. However, you must be prepared to withstand the short-term volatility that equities tend to exhibit.
Rather than hunting for individual stocks or stock sectors that are likely to outperform during inflation, long-term investors should focus on ensuring they are adequately exposed to all aspects of the global stock market. The best way to do this is via low-cost, fund-based vehicles.
While a moderate degree of inflation is generally good for the economy, rapid inflation can be disastrous, especially if you don’t have much income or you’re retired. Fortunately, you can take certain measures to protect against this risk.
The most effective strategies include:
- Maintaining a flexible budget that allows for temporary lifestyle changes
- Proactively structuring your portfolio to include smart positions in asset classes that minimize the effects of inflation
While the first strategy can be challenging to implement, it proves invaluable due to the financial breathing room it gives you. The second strategy is sensible for anyone with an investment portfolio, whether your assets are housed in a tax-advantaged retirement account, a taxable custodial account or both.
It’s important to note that your efforts to mitigate the effects of inflation should not dominate the design of your financial portfolio. Rather, the strategies should complement your overall investment strategy.
Always strive to maintain a holistic view of what you’re hoping to achieve with your investments and your investing horizon. Don’t lose sight of your need to preserve capital, generate income, grow your wealth and manage liquidity. If you haven’t considered these needs or you lack a clear understanding of how to address them, consult with a reputable financial advisor to assess your situation.