Inflation erodes the purchasing power of your dollars. When excessive it can be a significant setback to your portfolio’s performance. It is something we always need to consider in our long-term planning; our expectations for inflation help drive what we need our investments to achieve to lift us to our goals.
The latest consumer price index (CPI) from the Bureau of Labor Statistics has caused some mild alarm. The CPI rose 0.8 percent in the month of April, and 4.2 percent since April 2020. These numbers were both unexpected and larger increases than we have seen in a long time.
The Current Situation
Some of the present problem is situational, and the government does not seem to think there is cause for alarm. In particular, increasing demand for goods is causing a strain on an already overstrained supply chain. Many industries and economies have not yet returned to their pre-pandemic normal.
There are significant shortages in microchips and in lumber, among other goods. These shortages may limit supplies of some finished goods, which results in increased prices, and the higher costs of materials is also passed to the consumer in the form of increased prices. Our government sees this as a temporary situation.
Other factors may not, however, be temporary. We have a labor shortage; many companies are struggling to fill open jobs. Companies that want to fill jobs may be forced to pay higher wages; these costs ultimately will be passed on to the consumer — adding to inflationary pressure.
When the labor market eases, wages don’t just drop; those increased costs are permanent.
The housing market is on fire. Housing prices are rising astronomically. The value of housing is a major factor in rent, which will trend up with housing costs. As housing cost rise, workers will demand higher wages to make ends meet, ultimately putting additional pressure on wages and the cost of goods.
Real estate price gains also tend to be permanent, that is, most real estate gains will be held; these increases are also not going away.
Printing more money contributes to the problem. Increases in the supply of money devalues it and leads to increases in prices. The U.S. government has printed a lot of money and has not faced its day of reckoning.
The government is not worried.
I am. And have been.
Increased inflation decreases your real rate of investment return. Investing is a long-term endeavor; we save for near-term items and invest for long-term needs. In the long-term, a well-balanced portfolio provides the best protection against a variety of risks.
The strategies you should employ for long-term growth still hold. Growth investments may suffer temporarily, but should recover. Inflation, even excessive inflation, will most likely be temporary. Don’t throw away the basics.
But you can make some tweaks to protect your investments from inflation. These should be part of any long-term portfolio planning. Now might be a good time to revisit these strategies.
Protecting Investments Against Inflation
There are a couple of steps you can take to help protect your portfolio against the ravages of inflation. The two fundamental approaches to employ are to increase concentrations in inflation hedge assets and decrease concentrations in assets that have higher risk of loss during inflationary periods.
Gold is a good hedge against inflation. The value of gold tends to rise during inflationary periods, preserving the purchasing power of your investment.
Commodities are another potential hedge against inflation. Some commodity prices will rise in near direct proportion to inflation, again preserving purchasing power.
Investors can participate in gold or commodities through exchange-traded funds (ETFs); they do not have to do it directly. This can help diversify your inflation hedge assets, helping to minimize your risk.
Real estate is also a good inflation hedge asset. Inflation tends to drive up real estate prices, helping to keep prices whole in real terms. Investors can invest into real estate directly, through real estate investment trusts or ETFs.
Treasury Inflation Protected Securities (TIPS) are specifically designed as a hedge against inflation. TIPS values are tied to the CPI, providing a direct hedge against inflation. Since the interest paid by TIPS is set as a rate off the base value, increases in the base value also increase the dollar amount of the interest payments.
Some stocks can be a good hedge against inflation: consumer staples in particular, as price increases in staples can be readily passed on to the consumer. Other stocks, including many higher dividend paying stocks, may not do well during inflationary periods.
From an investor standpoint, inflation protection can be built into a portfolio without sacrificing long-term performance.
TIPS, for example, may be too conservative for many long-term investors. Real estate and commodities, on the other hand, may be a far better fit for a portfolio designed for long-term appreciation. TIPS might be better used to preserve shorter-term assets when inflation seems likely.
The second part of the inflation protection strategy is reducing exposure to assets which may not fare well during an inflationary period. As mentioned above, some stocks tend to perform poorly; higher dividend stocks in particular. Investors may want to consider what level of these are appropriate to hold if they feel inflation may be becoming an issue.
Bonds can also be problematic during inflationary periods. Each issue should be considered independently.
Longer duration fixed income investments have additional risk as they are more likely to decline in value when interest rates rise — as rates tend to do during inflationary periods. Shorter duration bonds may fare better. Some low-grade bonds may do well as investors seek higher yields.
The Bottom Line on Inflation and Investments
Having concern is not the same as panicking. There is no reason to panic; there may be reason for concern.
The fundamentals of long-term portfolio construction still hold. Inflation does not violate good investment strategy. But even good strategy can be tweaked to prevent undo harm. When risks appear higher, a prudent investor will consider whether or not changes are appropriate.
A well-designed portfolio does not need to be redesigned, but may benefit from careful consideration in light of the near-term risk potential.
A well-designed portfolio has some inflation hedge built in. There is real estate, and some commodities. Consideration has been given to the bond holdings and interest rate sensitivity.
But when storm clouds gather, we still check to see if we have an umbrella. There are signs of possible higher inflation. The dark clouds may pass. As for myself, I would rather be prepared for the worst.