Periods of inflation create wealth management challenges for consumers and investors. Fortunately, specific investments can help you hedge against inflation and keep rising prices from drastically affecting your investment portfolios. Understanding inflation-resilient investments can help you strategize for the future.
What Is Inflation?
Inflation is a rise in prices for a diverse range of goods and services over a specific period that translates into a decline in purchasing power. Economists usually measure these price changes over a year, showing how broadly prices fluctuate. Over time, inflation decreases the currency’s value because the same amount of money can purchase fewer goods, utilities, and services.
Inflation is expressed as a percentage of the price change from the same period the previous year. When purchasing power increases due to falling prices, the result is called deflation.
What Causes Inflation?
Inflation is a complex economic concern with many changing variables. Several economic factors can contribute to inflation, including:
- Production costs: When the cost of raw materials and wages increases, production costs rise. Manufacturers and producers pass added costs on to consumers through price hikes in their goods and services.
- Consumer demand: When consumer demand for a specific product or service suddenly increases, businesses and suppliers sometimes can’t keep up with the demand. As a result, supply decreases and prices typically increase.
- Expansionary policies: Governmental fiscal policies can increase discretionary income for businesses and consumers. Increasing the minimum wage, investing in infrastructure, and cutting taxes can give companies and individuals more spending money, raising demand and leading to price hikes.
- Inflation expectations: Inflation can also be a self-fulfilling prophecy. If workers ask for higher wages for fear of inflation, companies usually respond by increasing their prices. Businesses may also raise prices if they expect raw materials to cost more.
- Devaluation of currency: Devaluation is when one currency becomes worth less relative to another currency. For example, if the exchange rate used to be $1 to £0.83, but now $1 only buys £0.75, the dollar has devalued. Devaluation makes it more expensive to import goods and can cause inflation if businesses increase their prices.
- Rising wages: Some experts see rising wages as a contributor to inflation, but not all economists agree. Workers may have more disposable income to spend, and increased demand could raise prices. However, past wage increases haven’t indicated a strong correlation with inflation. Additionally, businesses may see increased productivity, preventing demand from outpacing supply.
How Does Inflation Affect Investments?
Rising inflation can negatively affect many kinds of investments. For example, long-term bonds tend to have fixed interest rates that make the bonds’ value sensitive to inflation rates. The relative value of the bonds will fluctuate due to the decrease in spending power. During periods of high inflation, bond prices tend to fall.
Inflation affects stocks differently, though it can still be an uncertain period for investors. Inflation makes it more challenging for investors to assess a company’s future profitability or how it will handle growing production costs. Growth stocks also earn most of their cash flow in the future, which makes them more vulnerable to inflation.
Some investments make better hedges against inflation than others. Knowing where to put money during periods of inflation helps investors prepare for the impact of rising costs.
Inflation Hedge Investments
With the uncertainty of inflation, many potential investors may not know how to respond. Every investment brings some degree of risk, though specific investments provide greater protection against inflation rates. When investors search for how to make money during inflation, one solution is to invest in vehicles that will likely benefit from inflation. These investments include gold, real estate, treasury inflation-protected securities, short-term bonds, and cash.
Gold is one asset considered a hedge against rising costs because some investors flock to it during periods of inflation. Many people consider gold an alternative currency because it is still used when a country’s native currency loses its value. Although the linear relationship between gold prices and inflation is inconclusive, gold prices aren’t as susceptible to the fluctuations other assets experience.
Gold protects against inflation in the long term, over decades of ownership. The value of inflation hedging by holding on to physical assets like gold rather than holding onto assets that pay yields depends on the investor’s goals. As with every other investment, gold prices also fluctuate yearly. Gold investors must also consider the logistics of securing their gold.
2. Real Estate
Real estate income earned from renting out properties is another good hedge against inflation because real estate rental income tends to keep up with rising inflation rates. Investors in residential real estate can significantly benefit from inflation since everyone needs a place to live. As a result, rising interest rates often coincide with rent increases. Average apartment rent across the U.S. has steadily increased for the past several years.
Although a real estate investor’s expenses, such as insurance, will likely also rise during inflation, income-producing real estate still tends to produce higher rental income. Real estate investments in student and senior housing are currently appealing options because there is a constant need for them. If there is a stable demand for student housing, this can produce a steady cash flow.
3. Treasury Inflation-Protected Securities
Treasury inflation-protected securities (TIPS) are effective protection against inflation backed by the U.S. government. As costs rise, the price of a TIPS adjusts to maintain its real value. Inflation leads to a higher principal of a TIPS, while deflation leads to a lower principal. TIPS pays interest twice a year at a fixed rate. Upon maturation of the TIPS, the owner receives the original principal back and may receive a higher adjusted principal.
Investors in TIPS can hold them until they mature or sell them beforehand. TIPS provide government-backed inflation security, making them ideal for people looking for inflation hedging. However, these investments usually pay lower interest rates than other securities.
4. Short-Term Bonds
Short-term or floating-rate bonds may be safe to invest in during inflation since their interest rates are indexed to a benchmark, potentially making them less vulnerable to market fluctuations like inflation. Short-term bonds are also more resilient against rising interest rates than long-term bonds. If interest rates rise quickly, these investments will be less affected because they are shorter-term.
Since short-term bonds involve lower interest rate risk, they also tend to yield lower returns. Yet investors looking for protection against inflation may find these investments provide stability during inflation that they need.
5. Other Short-Term Investments — Money Markets, CDs and Commercial Paper
Many people also overlook the value of investing in money markets, certificates of deposit (CDs) and commercial paper during inflation. Money markets are mutual funds that invest in highly liquid instruments, including CDs and commercial paper. These investments have short-term maturity, making them less vulnerable to changing interest rates.
The financial instruments investors can invest in through money market funds are less volatile than many other investments. For instance, CD rates have recently dropped but may still outpace inflation rates, depending on how high a yield the CD rate offers.
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Defending your finances from inflation can be a challenging task. Investing in assets that hedge against inflation can be an effective wealth management strategy during these periods. Of all the inflation hedge investments, real estate has one of the highest probabilities of generating passive income and rising in value.
At 1031 Crowdfunding, we facilitate real estate investments and alternative investment vehicles. Our management team has performed a total of $2.2 billion in real estate transactions, and has the experience to navigate various real estate investment situations.
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