When making plans for your finances, one factor which you shouldn’t overlook is inflation.
As a long-term investor hoping to hold assets for several years, if not decades, you have to be wary of the effect of inflation on your investment.
This is because rising inflation rates reduce your purchasing power. They also the value of your investment, thereby making your profits less significant. Staying ahead of inflation requires skills and finesse.
You have to be adept at recognizing which assets can be used as inflation hedges. It also helps to know which indicators or metrics to use to judge the inflation levels and know how to position your finances appropriately.
You should also be able to reevaluate your target accordingly to protect the capital and gains which you have accrued. Some assets are better than others during inflation. As such, a regular review of your portfolio in terms of inflationary measures is needful.
Perhaps there has been no other time when investors have to be conscious of inflationary effects than now. The increase in money supply as a result of:
government stimulus, supply chain bottlenecks created by the pandemic, commodity super cycles, and shortage of labor has led to the rise of goods and services.
As such, it serves those with a long investment horizon to build portfolios that can withstand periods of inflationary pressures.
Read this next: Inflation: Should You Stick With Growth Stocks?
So how do you track inflation? There are a couple of metrics that financial analysts to track inflation
The Consumer Price Index (CPI) is regarded by many as the number one inflation gauge. This is a metric that measures the weighted average of prices of consumer goods and services. As such, the CPI measures price changes from the perspective of the consumer.
CPI can be calculated by taking price changes for each item and averaging them. CPI can be used to determine price changes associated with the cost of living.
Increments in the cost of production lead to higher prices of goods, which imply that consumers would have to spend more money. The Producer Price Index measures the average change in production costs over time.
It measures price changes from the perspective of the producer. A rise in PPI indicates that it costs manufacturers more to produce goods. These costs would eventually be passed on to the final consumer, which is exemplified by changes in the price of goods and services.
Choosing an investment that can protect your finances against inflation can be tricky.
There is no single asset that can protect your portfolio from the myriad of inflation streams. As such, it is important to keep a well-diversified portfolio that can weather the inflationary storm.
There are a couple of assets and investment vehicles that can offer investors the benefit of the doubt during times of inflation. Let’s have a look at them.
Commodities have long been regarded as inflationary hedges because their prices closely track purchasing costs.
Inflation occurs when the prices of items increase, thereby reducing the purchasing power of money. One critical factor that makes the price of goods rise is commodities.
An increase in the price of oil, wheat, copper, etc., equally translates to an increase in transportation, consumer staples, and industrial goods. As such, investing in commodities is one way to beat inflation.
Investors can invest in commodities themselves through the futures market or buy commodity-related equities. For example, you can invest in shares of oil companies to benefit from the rise in oil prices. Similarly, you can invest in copper mining companies to benefit from rising copper prices.
Though the stock market seems averse to inflation, historical data shows that returns on equities beat inflation in the long term.
When inflation starts to tick upwards, this reduces the current value of the future stream of earnings, thereby putting downward pressure on stock prices.
As such, investors tend to pull out funds from equities and rotate into government bonds. However, not all stocks can be used as hedges against inflation. Small-cap tend to underperform because they are sensitive to interest rates, growth, and high dividend yield stocks suffer during an inflation.
Real estate has traditionally been regarded as a preserver of wealth. Most finance savvy people use real estate to store their wealth and protect it against inflation. As inflation nudges up, the price of properties also increases.
This means that your real estate asset accrues more value during a time of inflation. As such, landlords can pass the costs to tenants.
If you don’t have the capital to invest in real estate directly, you should consider investing in Real Estate Investment Trusts (REIT) which are publicly traded portfolios of companies that own operate, and/or finance income-generating real estate.
Gold is the industry’s number hedge against inflation, though its efficacy is being questioned in recent times due to the growing popularity and acceptance of cryptocurrencies such as Bitcoin.
When there are doubts about the stability of a currency, investors seek out gold as a safe store of value.
Alternative investments are usually below the radar of most investors due to their illiquid nature.
Tangible assets can include:
Collectibles can be used to preserve wealth and guard your finances against inflation. Though it is difficult to peg prices to alternative investments, the value of these items is expected to appreciate over time, thus providing returns greater than the inflation rate.
Treasury Inflation-Protected Securities are perhaps the most straightforward hedge investors can place during times of inflation. These securities are ideal instruments for investors hoping to insulate their finances from inflation.
The value of TIPS is directly correlated with inflation as their coupon payments are adjusted based on inflation. During inflationary periods, TIPS tends to increase in value and payout more interest holders.
This may sound ironic, but during periods of inflation, the borrower stands to gain more than the lender.
This is because as inflation rises, the amount of money in circulation increases. While the value of your money is reduced, the amount of money you owe remains the same. For example, if you owe $1000, the value (purchasing power) of the money may have reduced, but the amount ($1000) remains the same.
So, the present value of cash now is worth more than its future value.
Thus, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it. Though debt seems like the opposite of investment, incurring it during periods of inflation can be a good financial move.
Inflation affords investors the opportunity to diversify their portfolio and broaden out to other sectors of the market which stand to gain from rising costs and lower purchasing power.
Make sure your portfolio is exposed to sectors such as health care and consumer staples that thrive in a depressed economic environment.
The world is a global village.
This implies that investors can now invest in other stock markets other than those in their resident countries. During the period of inflation, investing in foreign economies or emerging markets can be a good defense against inflation in one’s own country.
We all know the adage "Buy even when there is blood on the streets”.
Most people tend to liquidate their assets, most especially stocks during inflationary periods. If you are a long-term investor, you stand to gain from the sell-off in assets because you would be getting good stocks at bargain prices.
As such, you should buy when others are selling and maintain your position till the bull crowd comes back again. This is a sure way to increase your net worth, provided you have an iron stomach for the bearish sentiments and price corrections.
Inflation can erode the value of your assets.
As such, it makes sense to make a plan for it while structuring your investment portfolio. By tracking inflation, you can maintain and increase the value of your finances.
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