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03 Jul, 2022
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Understand inflation’s meaning and what assets to invest in that are protected against it.
Inflation – A Brief Overview
To understand exactly what inflation is, consider the following example. The value of INR 100 will not be the same a decade from now and won’t be able to buy you the same value of goods as it does today. Inflation helps discern the average price level of a set of goods and services available in an economy. This term is used to refer to the hikes in prices over an outlined time frame.
It is because of inflation that a specified amount of a given currency will be able to purchase less than it did in the past. Owing to this very fact it is important to identify appropriate strategies and investments that can be hedged against inflation.
The extent to which inflation transpires within an economy is dependent on current events. Two factors that impact inflation include wage hikes and rapid rises in the price of raw materials. It is important to understand that inflation is only natural and can be hedged against in several ways. Continue reading to understand what these are.
Assets that Help Hedge Against Inflation
The list outlined below highlights some of the key assets that are ideal investments that can be hedged against inflation.
#1. Gold
This asset tops the list as it is often perceived as an alternative currency by many. This attitude is particularly pronounced in countries where the native currency isn’t strong and is falling in value. Said countries often utilize gold or other other strong currencies when their own currency has failed. Since gold exists in a physical form and is real, it is more likely to retain its value.
That said, when inflation rises, central banks are likely to enhance interest rates keeping in mind their monetary policies. By maintaining an asset like gold that doesn’t pay any yields, you are depriving yourself as it isn’t as valuable as assets that do pay yields. This is most pronounced when rates are higher, and the alternative assets pay greater yields.
While there are superior assets to invest in when seeking protection from inflation, all strong portfolios require diversification and therefore gold ought to be considered.
#2. Commodities
There are several goods that fall under this broad category including but not limited to foreign currencies, natural gas, oil, electricity, precious metals and grain. There exists a unique relationship between commodities and inflation as the former highlights the latter’s arrival. As the price of a commodity surges, so too does the price of goods that the commodity is used to make. Thankfully it is possible for you to invest more broadly in commodities via ETFs (or exchange-traded funds).
Prior to deciding to invest in commodities, you must be aware of the high volatility that is tethered to them and should proceed with caution when participating in commodity trading. Since commodities are tethered to demand and supply factors, minor changes in supply caused by conflicts or geopolitical tensions can negatively impact commodity prices.
#3. Consider 60/40 Stock/ Bonds
By aligning your portfolio to be made up of 60 per cent stocks and 40 per cent bonds, you can create a conservative portfolio for yourself. This straightforward investment strategy is fairly easy however it does have certain shortfalls. In contrast to a portfolio that is entirely made up of equities, this 60/40 stock and bond portfolio will make comparatively fewer returns. Further, underperformance is likely in the case of these portfolios over long time frames in comparison to equity-only portfolios owing to the impact compounding interest has.
While this portfolio will help protect you from inflation, you are likely to miss out on returns in comparison to a portfolio made up of a greater percentage of stocks.
#4. Real Estate Investment Trusts (or REITs)
These trusts are made by companies that own and operate real estate that generates an income. It isn’t out of the ordinary for property prices as well as income drawn from rent to rise once inflation rises. A REIT is made up of a pool of real estate that generates dividends for its investors.
The shortfalls associated with REITs pertain to their sensitivity to need for other high-yield securities. Once interest rates rise, treasury securities tend to become attractive. This can lead to funds moving away from REITs and can cause their share prices to dip.
Another aspect to consider is the fact that REITs need to pay property taxes which can constitute as much as 25 per cent of the overarching operating expenses. In case municipal authorities choose to hike property taxes in a bid to offset budget shortfalls, this can reduce the cash flows directed toward shareholders.
#5. Income from Real Estate
This income is drawn from renting out a property you own. As made clear in the previous point, inflation works in the favour of real estate. This is owed to the fact that as inflation rises so too do property prices. This translates to landlords being able to command higher rents over time.
Final Thoughts
Although the aforementioned five securities make for good hedges against inflation, they do have certain shortfalls as indicated above as there exist several different types of inflation. Always take into account your own investor profile, your threshold for risk and the amount of capital you are willing to risk prior to investing in any of these securities. Visit the Angel One website to learn more about making wise investment decisions.
Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.
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