Inflation presents special challenges to investors. Even if your investments are growing in value, inflation is still reducing that value on the backend. The only way to deal with it successfully, is to be sure that your money’s in investments that are likely to benefit from inflation, while avoiding those that tend to be especially hard hit.
So how do you find investments that benefit from inflation, instead of losing their value?
Here are six ways to brace your investments for this situation.
1. Keep Cash in Money Market Funds or TIPS
With inflation now being officially invisible, interest rates are downright microscopic. If you suspect that inflation will be a factor in the future, it’s best to keep any cash type investments in money market funds.
While it’s true that money market funds currently pay next to nothing, they’re the cash investment of choice during periods of rising inflation.
Here are two reasons why this is true:
- Because the rates they pay fluctuate continuously with interest rates, and they automatically adjust upwards as interest rates rise. There’s no need to chase higher yielding cash-type investments.
- Since money market interest rates rise with the general market, you won’t have to face the loss of market value that plagues fixed-rate investments during times of inflation.
When inflation hits, money market funds are interest-bearing investments, and that’s where you need to have your cash parked.
They’re available in terms of 5, 10 and 30 years, and pay interest twice annually. And each year the value is adjusted based on the Consumer Price Index (CPI). This gives you regular interest income, plus an annual adjustment for inflation to your principal value.
2. Avoid Long-term Fixed Income Investments
The worst investment to put money into, during periods of inflation, are long-term fixed rate interest-bearing investments. This can include any interest-bearing debt securities that pay fixed rates, but especially those with maturities of 10 years or longer.
The problem with long-term fixed income investments is that when interest rates rise, the value of the underlying security falls as investors flee the security in favor of higher yielding alternatives.
That 30-year bond that’s paying 3% could decline in value by as much as 40% should interest rates on newly issued 30-year bonds rise to 5%.
Long-term fixed income investments are excellent when inflation and interest rates are falling. But if you believe that inflation is about to take off, you’d be better off moving your money out of long-term fixed income investments, and into shorter-term alternatives, particularly money market funds.
3. Emphasize Growth in Equity Investments
Many investors try to balance out their equity portfolios by investing in high dividend-paying stocks, or in growth and income funds, and this can work especially well during periods of price stability. But when inflation accelerates, it can hurt your investment returns.
This is at least in part because high dividend paying stocks are negatively affected by rising inflation in much the same way long-term bonds are.
The better alternative is to invest primarily in growth type stocks and funds. You should also emphasize sectors that are likely to benefit from inflation. These can include energy, food, healthcare, building materials and even technology. Since all are likely to rise in price with inflation, they’re likely to perform better than other equity sectors.
4. Commodities Tend to Shine with Inflation
While there isn’t an exact correlation between price levels and commodities, certain hard assets have traditionally been favored by inflation. Precious metals come to mind immediately, particularly gold and silver. You can hold precious metals in direct form, with coins or bullion bars, but you can also invest indirectly through ETF’s that hold actual gold.
You can also invest in gold mining stocks, or in funds comprised of these stocks. However, these are stocks, and not the actual metal itself. They also tend to be extremely volatile, even during times when gold prices are rising.
A more predictable hold on the stock side will likely be energy stocks and funds. This is especially important since rising energy prices are often one of the primary drivers in inflationary environments.
5. Inflation is Usually Kind to Real Estate
Over the long-term, real estate is also usually an excellent investment response to inflation. Real estate is actually the ultimate hard asset, and often sees its greatest price appreciation during periods of high inflation. This is especially true since as rents rise, people become increasingly interested in owning as a way of getting the tax benefits that help offset the general level of inflation.
You can invest directly in individual properties — residential or commercial — but you can also use real estate investment trusts (REITS). However you handle it, real estate should have a place in your portfolio if you anticipate rising inflation.
6. Convert Adjustable-Rate Debt to Fixed-Rate
Technically speaking, this is not actually an investment move but it could be one of the most profitable strategies you can make in response to rising inflation.
Periods of low or declining inflation favor adjustable rates over fixed rates when you borrow money. But the dynamic reverses when inflation rises. Higher inflation results in higher interest rates, which means that as inflation accelerates, your adjustable rates will continue to rise — even to potentially unsustainable levels.
If you believe inflation is coming, you should begin rolling your adjustable rate debt over to fixed rates. This should include credit cards, home equity lines of credit, and especially your first mortgage, if it happens to be an ARM.
Prepping Your Portfolio for Inflation
The low rates you’re enjoying right now could evaporate in a matter of months, raising your cost of living. Converting them into fixed rate debt now is one of the best ways that you can protect your cash flow.
Repositioning is important if you think inflation is coming. This is especially true since inflation has been low or declining for at least the past three decades.
But if there’s a change in direction, it can be quite dramatic. Any steps you can take to prepare in advance will payoff handsomely, especially over long-term.
How do you brace your portfolio for inflation? What’s a strategy you use to protect your investments?