Inflation is a topic that gets a lot of attention from the media and the general public. And for a good reason, too – it can significantly impact our lives. While inflation can be bad for some people, it can also be good for others. Managing your finances can be challenging, particularly during times of high inflation.
Fortunately, there are some steps you can take on how to profit from inflation, like protecting your finances, particularly your investment portfolio, from the effects of rising prices.
While it is impossible to predict when inflation will level off, you do not have to avoid investing during inflation. It is an excellent time to review your portfolio to ensure that your investments still hold their value.
This article will explore profiting from inflation by investing in certain options. From real estate to commodities and more, read on to learn how to profit from inflation and the investment options that can help you gain such profits.
What Is Inflation?
Inflation is an economic concept that refers to the sustained increase in the prices of goods and services in an economy. It is usually measured as the annual percentage change in the prices of a basket of selected goods and services.
Inflation can be both beneficial and detrimental to an economy. For example, it can lead to higher prices for consumers, which can, in turn, lead to lower demand for goods and services. However, inflation can also spur economic growth by encouraging businesses to invest in new production capacity and create jobs.
Several factors, including increased demand for goods and services and production shortages, can cause inflation.
The three major types of inflation are as follows:
- Demand-pull inflation: Demand-pull inflation occurs when demand increases at a rate that supply cannot keep up with, resulting in higher prices.
- Cost-push inflation: Cost-push inflation occurs when business production costs (such as the price of raw materials or workers’ wages) rise and consumer prices rise to compensate.
- Built-in inflation occurs when workers demand higher wages due to rising living costs. This can result in a feedback loop in which companies raise prices in response to rising labor costs.
Whatever type of inflation the economy faces, it can all have an impact on you and your finances.
How Does Inflation Affect Asset Values?
While the effects of inflation on the economy and asset values can be unpredictable, history and economics can provide some guidelines.
Inflation is especially damaging to the value of fixed-rate debt securities because it devalues interest payments and principal repayments. Lenders lose money after adjusting for inflation if the inflation rate exceeds the interest rate. As a result, investors may pay attention to the real interest rate, which is calculated by subtracting the inflation rate from the nominal interest rate.
Long-term fixed-rate debt is more vulnerable to inflation than short-term debt because the effect of inflation on the value of future repayments is proportionally greater and accumulates over time.
The assets that perform best under inflation are guaranteed to generate more cash or increase in value as inflation rises. A rental property subject to periodic rent increases or an energy pipeline charging rate tied to inflation is two examples.
Why consider Inflation?
Regarding investing, inflation is one of the most important factors to consider. Why? Because, over time, inflation can eat away at the purchasing power of your investment portfolio, it is important to invest in assets that can outperform inflation.
Inflation has several unsettling effects, the most obvious of which is that it gradually erodes your purchasing power. A dollar will buy fewer goods and services as inflation sets in. Because interest rates have been unusually low over the last decade, long-term investors and retirees alike have become more complacent about the threat of inflation.
In the future, the threat of inflation must be recognized as a real threat to a comfortable retirement if not properly accounted for. Inflation adds to economic uncertainty. Inflationary pressures compel the Federal Reserve Board to take action, which is expected to raise interest rates in response.
In the short run, the Federal’s actions can cause stock market volatility, and rising interest rates can cause bond funds to lose value.
If nothing else, the threat of inflation (and increased uncertainty) is another reason to reconsider your investment strategy to ensure that your assets are properly diversified. A well-diversified portfolio that is not overly concentrated in any one asset class is a good place to start when it comes to protecting your finances from inflation.
How Can Inflation Be Tracked?
There are several ways to track inflation, but the most common is by tracking the Consumer Price Index (CPI). The CPI measures the average price level of a basket of goods and services commonly consumed by households. The CPI is released monthly by the Bureau of Labor Statistics.
In addition to tracking the CPI, investors can also track inflation by looking at prices for specific goods and services they are interested in. For example, if an investor is interested in Gold, they can track the price of Gold over time to see how inflation has affected it.
Investors can also use inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), to hedge against inflation risk. TIPS are bonds issued by the U.S. government whose principal and interest payments are adjusted for inflation.
Finally, investors can use commodities as an inflation hedge. Commodities do well when inflation rises because underlying fundamentals, such as supply and demand, drive their prices.
Pros And Cons Of Inflation
Every investment hedge has advantages and disadvantages, just like every other type of investment. Additionally, the various assets described above have both positive and negative characteristics.
The primary advantage of investing during inflation is preserving your portfolio’s value. The second reason is that you want your nest egg to grow. It can also lead to diversification, which is always a good thing to consider.
Spreading risk across multiple holdings is a time-honored method of portfolio construction that is equally applicable to inflation-fighting as it is to asset-growth strategies.
Pros
- Inflation that is low and stable can be an indication of a growing economy.
- It helps people who have fixed-rate debt, such as mortgages.
- It encourages people to buy now rather than later.
Cons
- Inflation lowers purchasing power because each dollar buys fewer items.
- Retail consumers suffer as prices rise across the economy.
- It is detrimental to retirees who rely on fixed incomes.
- The Federal Reserve is compelled to act.
How To Profit From Inflation
Some investments outperform others when it comes to profiting from inflation. Keep the following points in mind when deciding where to invest your money.
1. TIPS
TIPS (Treasury Inflation-Protected Securities) are a type of bond issued by the United States Treasury. Treasury to protect investors from falling purchasing power.
TIPS are indexed to maintain their real value as inflation rises. As a result, they are an appealing investment option for investors seeking to preserve capital.
2. Real Estate
Historically, real estate investments financed with a fixed mortgage rate have been a good bet during inflation. As previously stated, rising inflation causes an increase in property values; however, with a fixed mortgage rate, your monthly mortgage payment remains constant.
Real estate can be purchased directly or through the purchase of shares in a real estate investment trust (REIT), which allows you to own stock in real estate companies. This method is ideal if you don’t have the money, time, or experience to buy and manage your property.
3. Commodities
Commodities are raw materials and natural resources that are required for the production of goods. Examples include gasoline, steel, corn, and lumber.
Commodity prices typically rise in tandem with inflation, which is why they can be used as a “hedge” against inflation. Commodity prices, like most investments, can be volatile, inflationary, or not. Rather than focusing solely on a single commodity, invest in funds that track the entire market, such as commodity mutual funds.
4. I-bonds
I-bonds (or inflation-indexed bonds), like TIPS, are designed to keep pace with inflation, making them an excellent investment if you want to profit from inflation.
While I-bonds do not provide extremely high returns, they virtually guarantee that you will earn back your principal investment, making them an excellent way to protect your purchasing power while adding a low-risk asset to your portfolio. This is especially true during periods of high inflation, when other investments, such as stocks, are likely to lose value.
5. Value Stocks
Value stocks outperform growth stocks during periods of inflation. While their prices are unlikely to rise as quickly as those of growth stocks, they are less volatile overall.
Value stocks have low share prices compared to the company’s financial performance. For example, a company with a track record of increasing sales, earnings, and cash flow represents an appealing investment, so the share price is likely to rise. If a company checks all of those boxes but has relatively low share prices, it is most likely a value stock.
6. Equities
During inflationary times, stocks are generally a haven. This is because stocks have historically produced total returns that outperformed inflation. And some stocks outperform others in terms of inflation resistance. Many recommended lists include small-cap, dividend growth, consumer products, financial, energy, and emerging market equities. Industries experiencing post-pandemic recovery, particularly travel, leisure, and hospitality, are also getting the thumbs up.
7. Gold
Many investors use gold as an inflation hedge, particularly if the country’s currency loses value. Gold, as a real asset and a commodity that we felt needed to be mentioned separately, tends to hold its value fairly well and can be a calming investment for investors during uncertain times. Of course, this is not a perfect investment, but it can be useful as part of a diversified portfolio as inflation rises.
How do Personal Situations Affect Your Inflation Investing?
While many investors consider this inflation hedges valuable additions to their portfolios during inflationary periods, they are not always appropriate for all investors. Before making any investment decision, consider your personal goals, time horizons, and risk tolerance.
For example, during periods of normal inflation, investors nearing retirement should shift most of their portfolios into cash and fixed-income investments.
The fact that inflation is on the rise does not necessarily imply that risk-averse investors should put all of their money into equities, commodities, and other relatively risky investments. Instead, they may allocate only a small portion of their portfolios to inflation hedges while remaining consistent with their asset allocation.
Conclusion
Inflation is a topic that gets a lot of attention from the media and the general public. And for a good reason, too – it can significantly impact our lives. TIPS, real estate, commodities, and I-bonds are various ways to profit from inflation.
As inflation accelerates, investors seeking to protect their portfolios are advised to favor equities over fixed income while also considering exposure to real estate and commodities. REITs, commodities, and stocks in depressed sectors like leisure and hospitality may offer opportunities for growth that outperform inflation.
