How To Hedge Against Inflation

For the past few decades, we've experienced an average rate of inflation between 2% and 3%.

But then, something happened. A global pandemic shut down the world's economy and created major supply shortages. Governments responded around the world with unprecedented money printing by central banks.

All that new money in circulation led to massive increases in consumer spending and put further stress on the global supply chain. Additional government deficit spending, piled on top of increased demand and shortened supply, has caused high inflation.

Rising inflation can cause a slew of problems, but for us investors, it means we need to make a better return on our investments in order to generate wealth.

Under current conditions, the average return you'd get by investing in the S&P 500 won't cut it. But there are investments you can make that hedge against inflation — investments that protect investors from the declining purchasing power of money.

How Inflation Impacts Your Money

Inflation is the devaluation of a national currency. In layman's terms, it means something, i.e., a car or a carton of eggs costs more today than it did just last year.

How much more?

That depends on the inflation rate. While prices typically rise 2-3% each year, they rose, on average, more than 8% this past year.

Some things, including utilities and groceries, have been impacted more than others, increasing in price by upwards of 10% and even as high as 33% (piped gas).

While this inflation rate is nowhere near hyperinflation, it still means the cost of living has increased exceptionally. The rising cost of living impacts everyone's wallets.

Here's how:

You Have Less to Invest

Assuming you had enough money to cover your expenses, save, and invest before the recent inflation rises, you likely have less to save and invest now. This is because rising prices have likely made your expenses more costly.

If your income hasn't increased to keep up with inflation, which is the case for many Americans, the same amount of money has to stretch much further.

This can cut into the amount you have to invest. But, take heart, you can and should invest even if you only have a small amount of money available to do so.

You'd be shocked at how a little bit of money can grow into substantial wealth when it's invested in the right places…

You Need More to Retire On

Another way inflation impacts your money is its effect on your retirement portfolio.

If you were previously planning to retire on $2 million, the decreasing value of the dollar means you will likely need much more than that to live the same lifestyle. That $2 million will have a decreased purchasing power than you initially planned for.

For this reason, you have to adjust how much you will need to retire on and how much higher the return on your investment portfolio will need to be to offset inflation.

Your Cash is Losing Value

This may be hard to hear, but anything you've had sitting in the bank over the last year, earning a measly 0.5% interest rate, has significantly decreased in value. Any cash savings are worth roughly 7.5-8% less today than they were worth a year ago.

That's a big difference!

Investments That Hedge Against Inflation

Inflation has some not-so-great effects on your wallet, but inflation hedging can help offset those effects. Inflation hedging is the practice of reducing the impact of inflation on your wealth through investing.

Here are five inflation hedges, in particular, that can help you preserve and even grow your wealth. I'll cover the pros and cons of each asset class and which one I think is the best option to beat high inflation.

Series I Savings Bonds

I'm usually not a big fan of bonds. And that's because they usually provide a fixed interest rate that barely outpaces inflation.

When inflation rates are low, there are better ways to grow your wealth than bonds. However, when inflation rates are high, there are some types of bonds that can help hedge against rising prices.

Series I saving bonds earn monthly interest that equals a fixed rate + the rate of inflation, which is adjusted twice a year.

So, yields go up as inflation goes up.

For bonds issued between May and October of 2022, the yield was 9.62%, which means investors will earn 9.62% on their investment for the next six months, after which the rate will adjust. That series filled up so fast that the TreasuryDirect.gov website crashed and many investors were not able to lock in that rate.

I think of I-bonds as a high-yield savings account. If inflation continues to rise, the bond yields will continue to rise, and your money at least won't lose its buying power. It's inflation protection, but that's all. It will not increase your buying power.

Keep in mind, you can't cash out an I-bond until at least a year from the issue date and at least five years from the issue date without penalty. Also, you don't get paid the interest. It accrues. You get it when you sell the bond. And there's another rub; that rate can change fast. The current rate is just 6.89%, a drop of 3% in just six months.

And one more thing: You can only invest $10,000 per year in I-bonds.

Treasury Inflation-Protected Securities

Another potential inflation hedge is purchasing US Treasury inflation-protected securities, AKA TIPS.

Like all US Treasury securities, TIPS bonds pay interest on the money you lend to the government. However, unlike regular bonds but like I-bonds, the rate you get from TIPS isn't a fixed rate, it changes based on inflation.

Regular bonds pay a fixed rate, which means if you're earning a 3% interest rate on a bond, but inflation is 8%, you're really earning a -5% return. That's no good.

TIPS, however, pay the inflation rate plus a margin of at least 0.125%. So, if the inflation rate is 8%, the rate of return will be at least 8.125%. If inflation rates rise, TIPS interest rates rise.

This means you can at least keep up with inflation, which is more than your saving account can say. But again, if you want to grow your wealth, I still wouldn't be excited about bonds.

Real Estate

Real estate investments can be an inflation hedge. When prices rise for everything from fuel to food, they also rise for real estate.

From 1890 to 2021, the average real (post-inflation) rate of appreciation for housing was .53% per year, effectively doubling the real cost of housing over that 131 years. This after-inflation growth means housing is better than break-even with inflation, but not much better.

If, however, you can secure a mortgage interest rate that is less than the rate of inflation, as many homeowners recently did, then real estate can become an effective way to substantially beat inflation. Rising interest rates are now making this more difficult.

Gold

Gold is one of the most popular inflation hedges. One reason people like to buy gold and other precious metals during times of high inflation is that it's a commodity.

Like real estate, if prices of everything else are going up, gold prices are likely to go up too.

Unless, as is the case today, the US dollar is stronger than other currencies in the world.

In that case, the dollar becomes like gold for many investors, and gold itself does not inflate at the rate of inflation. This is likely a temporary situation given that from 1800 to 2021, gold saw a real rate of return (post inflation) of .498% per year compounded while the dollar saw its buying power shrink from $1 to less than five cents.

So, gold can hold its value, but it won't necessarily increase your wealth, or at least, not like stocks can.

Stocks

Stocks have always been the most powerful investment vehicle to grow your wealth, and thus, one of the best ways to limit your risk in an inflationary environment.

Remember, the average annual rate of return for the S&P 500 is 7% versus a 100-year average inflation rate of 3%, so stocks, even if owned in a mutual fund or index fund, do a great job of increasing wealth well above the inflation rate.

In fact, the stock market as a whole crushed inflation from 1800 to today so powerfully that $1 invested in a diversified portfolio of stocks is worth $1,000,000 today after inflation is taken out. That's a million-to-one return in real buying power, and no other investment comes close.

But the catch is that you don't have 220 years for things to work out.

There can be decades when the stock market return is zero while inflation is roaring. From 1970-1980 the stock market index return was 0% while inflation grew to 14.9% per year. Holding a mutual fund or index during that decade was a disaster.

There is an answer to that problem, however. I'm talking about investing in individual companies that are anti-fragile.

Anti-fragile companies are those that have a huge competitive advantage.

Companies like this don't have to compete, meaning they can raise prices to keep up with inflation and continue to turn a profit.

They also tend to do well when things get tough, i.e., when the economic cycle takes a turn for the worse. This is because their weaker competitors often go up for sale or even fail during big economic downturns and the anti-fragile companies emerge stronger than ever.

Investing in companies like these by buying individual stocks is the best way to hedge against inflation.

How To Invest In Stocks in the Midst of Inflation

Despite rising interest rates, the US inflation rate is still high.

Given this, the Federal Reserve will likely continue to raise interest rates to tamp down inflation, which will likely cause some pain to the economy and could send us deeper into a recession.

So, how do you invest through sustained inflation and the threat of a major economic downturn? Here's how:

Have Your Watchlist Ready

Whether the market is up or down and inflation is high or low, the Rule #1 strategy remains the same: Invest in wonderful businesses and buy them at a deep discount.

To do this, you need to create a watchlist of wonderful businesses you want to invest in.

Remember to fill your watchlist with anti-fragile companies that have a big moat and can thrive during a recession. Have that watchlist ready so that you can buy those companies when the time comes.

Re-Evaluate the Story

There are times when it makes sense to re-evaluate your investments, and now is one of those times.

How does high inflation impact the businesses you plan to invest in? Will it hurt their profit margins? What about a recession? Are they strong enough to weather an economic storm?

If they have a weak moat or are losing customers left and right to the competition, they probably aren't the type of business you want to invest in when inflation is high.

To hedge against inflation, your investments need to be able to raise prices and produce positive returns even during a recession.

Wait for the Right Time to Buy

Once you are confident in the companies on your watchlist and you have determined the right price to buy them at that guarantees a margin of safety, practice patience.

Wait for the stock price to go down to your buy price, and then be prepared to act fast!

When it rains gold, it doesn't rain for long.

After you make your investment, the stock price can fall even further below the margin of safety price. You bought a $10 bill for $5, and now it's even more on sale for $3. You made a great deal, so feel great about it, but if you can find more capital, buy more!

As Warren Buffet has always said, "Be fearful when others are greedy and greedy when others are fearful."

Don't Be Afraid to Invest

Instead of being afraid to invest, be afraid of what will happen if you don't!If you don't invest your money in businesses that can produce a return that outpaces inflation, you may miss the opportunity of a lifetime.

Don't let that happen to you.

Use these tips to hedge against inflation, and you'll retain the value of your money and grow your wealth.

For a helpful resource that you can keep handy throughout this economic season, grab my Must-Have Investing Checklist. It will help guide you through the dos and don'ts of investing in any market condition and show you how to find solid and wonderful businesses to buy now.