When you build an investment strategy for the future, you hope to growyour wealth to help you enjoy life down the road. But inflation can havea significant impact on your savings. If your returns aren't outpacinginflation, you could find your future plans in peril.
The key to managing inflation and its impact on your investments isknowledge. To protect and grow your assets, it helps to first get up tospeed on inflation, historic rates, and its real impacts. Then you canlearn about common investments than can help hedge against inflation.This will help you start a conversation with your financial advisor abouthow to protect your wealth.
Inflation: A quick primer
Inflation measures the decline in purchase powering of a particularcurrency over time. In the U.S. purchasing power is generally measuredby looking at the Consumer Price Index (CPI). The CPI measures howmuch prices for everyday items are increasing on a year-over-yearbasis.
When the CPI goes up, a dollar buys less than it used to, and the cost ofliving becomes more expensive. When prices continue to rise,consumers are often reluctant to spend on anything that isn't necessary,which can cause a slowdown in the economy. When the economy slowsdown, many companies can show decreased sales, lower profits, andlower returns for investors.
The Federal Reserve3 tries to keep inflation around 2% per year. Andwhile it might not seem hard to achieve yields of more than 2%, inflationbecomes a formidable opponent when rising prices take a steep chunkout of your returns.
Real Estate Investment Trusts (REITS) can be a solid hedge againstinflation. That's because when prices go up, rents tend to go up too.
How inflation impacts investors
If you're an investor who's comfortably retired, you and your financialadvisor have probably shifted your investments towards wealthpreservation instead of growth. A conservative, income-producingportfolio yielding 5% will still keep you ahead of inflation when inflationrates are the target 2%. But when inflation rises to 6.2%,1 like it did inOctober 2021, your income-producing portfolio is now effectively losingmoney.
Even investors with portfolios yielding the average 10% to 11% rate of return of the S&P 500 have to take stock of steep inflation. Onceinflation is factored in, those returns dwindle to 3.8% to 4.8% — evenless if you have accounts where capital gains taxes are a consideration.
When your investments fail to keep pace with or outpace inflation, you'llburn through your savings at a faster rate and potentially find yourlifestyle and financial capabilities hindered.
How hedging helps combat inflation's impacts
There there's no telling whether prices will continue to rise. But there isa strategy that can help you manage inflation's impacts long-term. It'scalled hedging.
Hedging is investing in asset classes that tend to behave in ways thatcushion the impacts of inflationary times. Just as bonds tend to increasetheir yields when the economy declines, other asset classes can becomeshock absorbers by bringing returns and delivering income.
While your financial goals and risk tolerance are unique, the assetclasses below are commonly used to help investors hedge againstinflation. By learning a bit about the "superpowers" of each asset class,you can use that info to start a conversation with your investmentadvisor.
- U.S. Large Cap Dividend Growth Stocks. Many large U.S. companies have steady track records of consistent dividend growth. The income from quarterly dividend payouts can potentially help offset declines in stock value.
- Real Estate Investment Trusts (REITS). It's easy to forget that the CPI includes rents. So when prices go up, rents tend to go up too. According to Nariet, a global organization that advocates for REITbased investments, REIT dividends have out paced inflation6 in all but two of the past 20 years.
- Private Real Estate. In times of inflation, home prices typically rise. In fact, home prices increased 18.1% year-over-year as of August 2021.4While the pandemic may have contributed to this increase, in general your properties can increase in value even when the broader economy stalls. That's because the Fed typically keeps interest rates low to increase spending during an economic downturn. This, in turn, keeps mortgages accessible and home sales flowing. With robust sales, supply remains limited, so prices can increase even when the economy is otherwise slowing down.
- Commodities. According to research published by Vanguard, a 1% rise in inflation would produce a 7% to 9% rise in commodities.5 Commodities can include gold, agricultural products, and natural gas. You can invest in these through a wide variety of investment products, such as mutual funds, ETFs, and managed futures.
- Treasury Inflation-Protected Securities (TIPS). Issued by the U.S Treasury, these bonds adjust along with inflation. When inflation goes up, the principal value of TIPS also increases. In theory, this makes it difficult for investors to lose money.
While these aren't the only hedges against inflation, they show the widearray of investments that can help diversify your portfolio and offerupside potential when inflation is on the rise.Of course, diversification does not ensure against loss.
Protecting your wealth
The bottom line for inflation: It can impact your returns today in waysthat can impact your quality of life tomorrow. If you have concernsabout how inflation may affect your financial goals and whether yourinvestments are outpacing inflation, discuss your options with yourinvestment professional.
It's entirely possible you already have inflation hedges playing theirpart. But a straightforward conversation with your financial advisor canoffer peace of mind — and possibly lead to a more enduring strategy forprotecting your wealth in all economies.
Important disclosure information
This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circ*mstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
Diversification does not ensure against loss.
- Bureau of Labor Statistics, "Consumer prices increase 6.2 percent for the year ended October 2021," published November 19, 2021, accessedDecember 7, 2021. Back
- J.B. Maverick, "What Is the Average Annual Return for the S&P 500?"Investopedia, updated May 31, 2021, accessed December 7, 2021. Back
- The Federal Reserve, "Why does the Federal Reserve aim for inflationof 2 percent over the longer run?" accessed December 7, 2021. Back
- Michele Lerner, "The states and regions where home prices rose the most," The Washington Post, published October 27, 2021, accessedDecember 7, 2021. Back
- Vanguard, "How commodities stand apart as an inflation hedge,"published September 7, 2021, accessed December 7, 2021. Back
- Nareit, "REITS and Inflation Protection," accessed December 15, 2021. Back
- Diversification does not ensure against loss. Back
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