How Investing Can Help you Hedge Against High Inflation
Nearly two years into the Covid-19 pandemic, the health of our economy is top of mind for everyone, but especially for us as investors. It seems like recently inflation is being discussed everywhere, from media outlets to social platforms to board rooms. But, what is inflation? Why should we as investors care? And how can we make informed decisions to hedge ourselves against its effects today?
Let’s start by understanding what inflation actually is. According to Investopedia, “Inflation is the decline of purchasing power of a given currency over time.”
That means that as inflation rises, more money is needed to acquire the same amount of goods or services. Simply put, when inflation is on the rise, your dollars are worth less today than they were yesterday.
If we dig a little deeper, the Investopedia definition goes on to state that “a quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some time.”
Essentially, economists measure the inflation rate based on the increasing price of goods over a period of time. This rate is often expressed as a percentage. For example, if an average kitchen appliance costs $100 one year and $105 the following year, the inflation rate is 5%. That’s why you see not just an average inflation rate but also differences in inflation across each industry’s goods and services.
The inflation rate is a fundamental economic factor in every country. Economists keep a close eye on inflation at all times, as a change in the buying power of the U.S. dollar impacts the general cost of living for the American people, aka you and me. High Inflation typically indicates a deceleration in economic growth. Consumer dollars get them less than they did before. What can cause even more angst for people is that as the price of goods increase, their income remains the same, creating even more of a gap in their finances.
What causes inflation?
Economists have come to a general consensus on the cause of long-term inflation. When the money supply increases rapidly, the result is an increase in the price of goods/services. The country’s monetary authorities take necessary measures to manage the pace of economic growth in an effort to keep the economy running smoothly, resulting in an increase in the price of goods.
The three mechanisms that cause inflation include demand-pull, cost-push, and built-in inflation.
Demand-pull inflation occurs when the demand for a good or service exceeds the capacity to produce it. For example, the amount of people buying new cars increases faster than the manufacturer’s ability to make them. This exclusivity in new vehicles results in a higher price point.
Cost-Push inflation occurs when the cost to produce the goods increases. For example, the cost of new cars goes up because the price of rubber to make tires has increased.
Lastly, built-in inflation is a result of expectation over time. It is built on the idea that people expect inflation to rise at a consistent rate. In turn, they demand higher wages to maintain their lifestyle, repeating the built-in cycle and increasing the cost of goods. One expectation essentially feeds the other.
Why is inflation relevant now?
The annual inflation rate in America has seen its fair share of highs and lows over the decades. In the past 100 years, we have seen inflation rise and fall in correlation with the nation’s current state. As of October 2021, we have seen the highest spike since November 1990. The current inflation rate is 6.2%, double the long-term average of approximately 3% over the last several decades.
The federal government continues to assure the American people that the current inflation is transitory due to the Covid-19 pandemic, insisting that it will decrease over time. For more of a detailed analysis on the potential cause of the recent spike, check out this article by Forbes.
We want to state clearly that there is no way to know the economy’s future. Everything at this point is speculation. With that said, we believe that inflation will continue to rise in the short term. Why? Typically money trickled down into the economy through various government strategies so that there is not such a high spike in the money supply in the country. We are seeing now that trillions of dollars are being injected into the economy and directly into the hands of people through unemployment benefits and stimulus checks. Because of this sudden influx in the cash supply, we expect inflation to continue to rise, at least in the short term.
Why should we care about inflation rising right now, though? Won’t it eventually just regulate itself, as we’ve seen in the past? Again, none of us can predict the future. All we can do is act on the information we have at hand. Just remember, when inflation is rising, our money is quite literally worth less than it was yesterday. Cash that you’re stocking up in a bank account waiting to invest is losing value as we speak. While we can’t control inflation, we, as savvy investors, can hedge our bets by making certain decisions with our dollars.
Hyperinflation is when inflation becomes so high that your money literally is worth nothing. We have seen this happen in Germany post WWII. These are events that we have to really watch out for.
Where should we invest our money when inflation is on the rise?
As an investor, you have options regarding where you put your money. When inflation is on the rise, though, certain investment options may be more appealing than others because of their underlying mechanics and depending on your risk tolerance. Let’s look at alternative investment options and discuss how these vehicles can form a hedge of protection against rising inflation. NOTE: This is NOT personal investing advice. We always recommend conducting your research before investing.
Cash Flowing Real Estate
Of course, we are big fans of multifamily real estate in terms of cash-flowing vehicles. Mortgage interest rates are at an all-time low, which means it is incredibly easy to access the capital needed to purchase a property right now. If you already own a property, now would be a great time to consider taking out equity from your existing asset to purchase additional cash-flowing properties. The main advantage here is the rate of return vs. the rate of inflation. If you are yielding a 15% rate of return annually on your investments, you still will outpace the inflation rate of 6.5%, giving you a solid hedge against the declining dollar.
Precious Metals
You may have heard many people talk about recently putting their money in gold because of the high inflation rate. So why do people flock to gold and silver supply limitations? There is a limited amount of precious metal in the world, which means due to the laws of supply and demand, gold and silver hold their value over time. There is, of course, a cost of protecting these investments. You don’t want to just go out and buy a bunch of bricks of gold and stash them in your basement. Luckily many companies allow you to purchase the gold and take care of storage, safety, etc., for you. Learn more about investing in precious metals at Investopedia.
Inflation Prevention Bonds (TIPS)
Treasury inflation-protected securities, also known as TIPS, are a bond created by the U.S. government designed to help investors protect against inflation. TIPS is a low-risk investment option backed by the U.S. government. While they typically do not yield a significant return, it is considered a relatively safe investment tied to the consumer price index. Learn more about TIPS here.
Cryptocurrency
We know Bitcoin and other cryptocurrencies have become all the rage lately. These may be appealing in times of inflation is similar to gold and silver. Some cryptocurrencies are limited in terms of the total amount available. Only a certain amount of Bitcoin, Ethereum, Litecoin, etc., are available for purchase, which means they are not impacted in the same way the dollar is when inflation goes up or down. There are thousands of cryptocurrencies to choose from, these being some of the most popular. You will need to do your research regarding the underlying structure of how these currencies. Crypto investing is still a very volatile and high-risk investment and should be considered by investors who have higher risk tolerance and have spent time researching their investment method.
Stocks
And then there’s the stock market. Stocks are typically seen as a lower-risk investment method over the long-term time horizon because although the stock market goes up and down, it has historically gone up on average over time. Again, remember that past performance is not a promise of future performance. Though they still have a level of volatility if you are investing in individual companies. It’s also worth noting that when you think about what stocks are based on, businesses rely on goods and services to generate profit. As prices of these goods and services can increase in periods of high inflation, certain companies can get hit hard and find it challenging to generate a profit. If you invest in the stock market during times of high inflation, look for businesses with less exposure to price-sensitive goods and services, such as financial services, banks, or even get away from individual stocks and broaden your basis with mutual funds and EFTs.
Inflation happens. Economic change is inevitable. While we can’t control the state of the nation, we can control what we choose to do with our money. As the saying goes, “don’t put all your eggs in one basket.” Especially if that basket is your savings account. During rising inflation, the only sure thing is that leaving your cash in the bank is a conscious decision to let that inflation eat away at the value. Hedge your bets by making smart investments based on your knowledge, current portfolio, and risk tolerance. The times will continue to change. As investors, it’s our job to be ready to change with them.