For many of us, inflation has been a constant worry in recent years. One way to protect ourselves from the effects of inflation is by hedging our investments. So let’s take a look at how can we hedge against inflation.
What is Inflation?
Inflation is a type of rising in prices across the board. If you have ever been on a shopping spree at the grocery store, you will probably agree that inflation has caused some of our groceries to become more expensive over time.
The easiest way to think about it is as follows: Suppose you need 100 dollars today to buy certain goods and services. Inflation means that the next time you buy those same goods and services, you will need more than 100 dollars to do so.
In simple words, inflation is a rise in prices over time, while deflation is a fall in prices. This also means that there is only one form of currency inflation and two forms of currency deflation.
What Causes Inflation?
Inflation happens when there’s an increase in what’s called “monetary supply”. This includes everything from printing up money to issuing more debt. For example, when the U.S. government wants to boost economic growth they’ll typically print a lot of money to pay their expenses. This increases the supply and reduces the purchasing power of everyone else’s dollars.
How Does Inflation Impact Your Portfolio?
The two main ways that inflation impacts your portfolio are: on an absolute basis (i.e. it erodes the value of your portfolio) and on a relative basis (i.e. it increases your cost for trading). Let’s take a look at both of these effects in detail below.
Impact Of Inflation On An Absolute Basis
Monetary inflation means that the purchasing power of our money will decline over time. If you think about it, it does actually make sense. If the Fed takes $100 and prints 10 more $10 bills, then we need to spend 100 dollars today in order to get what used to cost 80 dollars yesterday.
Impact Of Inflation On A Relative Basis
When inflation goes up, expenses go up as well. And when expenses go up, so do our trading costs. As the price of a stock goes up with inflation, the number of dollars we need to spend on that stock also increases with inflation.
How to Hedge Against Inflation?
There are many ways to hedge against inflation. Most of the time, people will use interest-bearing investments such as Treasury Inflation-Protected Securities (TIPS), CDs, and bonds. These pay you a guaranteed return on your investment above the rate of inflation that we see in our economy today.
Typically, they have lower yields than regular money market instruments. However, when you consider that they partially insulate your portfolio from the effects of inflation, their yield is worth far more than its face value.
For example: Let’s suppose we invest $10,000 in a CD paying 3% per year over 5 years with an inflation rate of 2%. At first glance, it may seem like we’re not doing too well because we’re earning only 3% per year.
However, when you take into account the fact that inflation over this period is expected to be about 2%, we’re actually doing better than if we were invested in a regular savings account paying 1%. This is because while $10,000 could have bought us $11,000 worth of goods 5 years ago, it will cost us around $12,500 today (due to inflation).
So while CDs and TIPs typically have lower yields, they’re still valuable tools for insulating our portfolio from the effects of inflation.
If you’re looking for hedging against inflation, consider investing in treasury bonds. The easiest way to do this is by purchasing an index fund that invests in a basket of Treasury securities (like the Vanguard Total Bond Market Fund ETF) and holds them until maturity.