If you had a dollar for every time someone has mentioned high inflation this year, that extra cash might come in handy to offset the higher prices of everything you buy. The consumer price index (CPI) has continued to climb, rising 7.9 percent over the last 12 months and stressing Americans' personal finances.
In addition to eroding purchasing power, higher inflation can eat away at your income investments and the value of your portfolio. Should you consult with your financial advisor to change your investment strategy?
Investments and Inflationary Periods
How much your investments are impacted by periods of high inflation depends on how far you are from retirement, how much risk tolerance you have and your portfolio diversification.
When determining the value of your investments, you always have to account for adjustments due to changes in the inflation rate. Before the recent spike, the average annual rate of inflation was less than 3 percent.
The higher inflation rises, the more it can impact your investments. Then, when the Federal Reserve (Fed) steps in and adjusts interest rates to slow down the economy, businesses, lenders, borrowers, consumers and investors are affected.
Not all asset classes react the same way to higher interest rates or inflationary periods.
Consider also: Why You Need to Care About Shadow Inflation
In addition to eroding purchasing power, higher inflation can eat away at your income investments and the value of your portfolio.
Inflation Hedges
An inflation hedge is an investment that protects an investor when inflation increases. Hedges offer inflation protection by not losing value drastically when consumer purchasing power declines.
Historically, the best investments that serve as hedges are those that hold their value over time and aren't subject to volatility:
- U.S. Stocks: Legendary investor Warren Buffet is known for advising investors to invest in good companies with proven past performance that produce something without heavy capital investment. Equity funds serve as hedges, too.
- Index funds and Exchange-Traded Funds (ETFs): Index funds and ETFs are already diversified, have low volatility and take advantage of market growth. The S&P 500 is an example of an index fund performing well in this inflationary environment.
- Mutual funds: A mutual fund can perform well if not invested in fixed income securities, which tend to decrease during high inflation.
- Real Estate and Real Estate Investment Trusts (REITS): Real estate tends to be a good hedge because property value increases as inflation and prices go up. REITs are a popular alternative to physical property, with less liability and capital investment and allowing you to reap the benefits of an active real estate market via dividends.
- Commodities: The value of precious metals like gold and raw materials like steel, natural gas and oil tends to increase during inflation. However, the inflation protection of commodities can be overshadowed by the economic impact of compounding issues like Russia's invasion of Ukraine and resulting sanctions.
- Treasury Inflation-Protected Securities (TIPS): While these U.S. Treasury bonds are designed to protect investors from inflation by paying out at a fixed rate over a certain period, they are susceptible to changes in interest rates and can decline in value.
While these asset classes tend to perform well during high inflation, each one has its pros, cons, risks and taxation. Before changing up your portfolio or investment strategy, discuss your short-term and long-term goals with a trusted financial advisor.
Consider also: Advantages & Disadvantages of Investing in Real Estate
Diversification and Goal Setting
If you have a diversified portfolio and your asset allocation is spread across different asset classes, that is your best protection against inflation and deflation. While the current CPI is the highest in 40 years, economists and the Fed expect rates to drop close to pre-pandemic annual rates by 2023.
When you set up your portfolio, you not only diversify, but you set goals. Inflation doesn't change your long-term goals and may not adjust your short-term or long-term strategy. Talk with your financial advisor to decide if you need to react to the current inflationary environment.
Consider also: Inflation & Your Retirement Savings Plan