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Inflation Hedge

Investments that protect investors from the declining purchasing power of money due to inflation

What is Inflation Hedge?

Inflation hedge is an investment that is made for the purpose of protecting the investor against decreased purchasing power of money due to the rising prices of goods and services. The ideal investments for hedging against inflation include those that maintain their value during inflation or that increase in value over a specified period of time.

 

Inflation Hedge

 

Traditionally, investments such as gold and real estate are preferred as a good hedge against inflation. However, some investors still prefer investing in stocks with the hope of offsetting inflation in the long term.

 

 

Summary

  • Inflation hedge refers to investments that protect investors from the declining purchasing power of money due to inflation.
  • The investments are expected to maintain or increase in value during inflationary cycles.
  • Investors engage in inflation hedging with the goal of protecting the value of their investments and keeping operating costs on the lower end.

 

Why Companies Hedge Against Inflation

Listed below are some of the reasons why companies engage in inflation hedging:

 

1. Protect the value of their investment

The main reason why companies engage in inflation hedging is to protect their investments from loss of value during periods of inflation. Certain types of investments increase in value during normal economic cycles but decline during inflationary cycles after factoring in the effects of inflation.

For example, an investor may acquire an investment with an annual return of 5%. However, at the end of the year, when the investor plans to sell the investment, the inflation rate accelerates to 6%. It means that the investor will suffer a loss of 1%, which is a loss in their buying power.

To avoid inconsistencies in the value of their investments, investors go for stable investments that maintain or grow in value during periods of inflation. For example, real estate is considered a good inflation hedge because the rental income and the market value of real estate properties tend to maintain or increase during inflationary periods.

 

2. Keep operating costs low

When a company projects that its operating costs will increase during inflationary periods, they may make investments that help them keep operating costs low. Usually, inflation results in higher costs of producing goods and services, which tend to reduce portfolio returns. To cope with inflation, companies may be forced to raise prices for their products, cut their operating costs, or even accept reduced margins.

For example, during inflation, oil supplies fluctuate, and prices increase. They may greatly increase the operating costs for airlines. Oil is a major cost, and an increase in oil prices can greatly affect the profit margins for these companies.

Airlines can engage in inflation hedging by acquiring oil refineries to reduce the risk of fuel price hikes. In such a way, they produce jet fuel for their airplanes and jets instead of buying it from suppliers at the market rate.

 

How to Hedge Against Inflation

The government determines whether inflation will occur in the future or not by analyzing various economic indicators. It may also deploy measures such as the Consumer Price Index (CPI), which measures the changes in price levels of a basket of consumer goods and services in a household. When inflation occurs, the government will take action to manage the market volatility, but the prices of goods and services will continue to rise.

Investors can implement the following measures to protect themselves from the declining purchasing power of money during periods of inflation:

 

1. Buy Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities (TIPS) are government-backed bonds that are issued by the US Department of Treasury, and they are some of the safest securities in the world since they are backed up by the US Government. It means that they are free of default risk, and there is zero risk that the government will default on its obligation.

TIPs also includes an inflation protection component. They adjust the value of the principle according to the changes in the CPI. Although TIPS may not yield the highest returns, they are designed to increase in value as the rate of inflation increases, and may sometimes outperform treasuries if inflation reappears.

However, TIPS are not wholly perfect since they may temporarily decline in value when interest rates increase. TIPs are ideal for investors looking for protection against inflation and credit default, and inexperienced investors can purchase them through a mutual fund or exchange-traded fund (ETF).

 

2. Add stocks to your portfolio

If inflation reappears, investments in stock will enjoy an advantage while the bond market will suffer since it earns a fixed income all throughout. Stocks hedge against inflation in two main ways, i.e., stocks pay a dividend, and they grow over time. As companies grow their net revenues, they also increase the dividends distributed to shareholders, which assures investors higher cash flows in the future.

The higher cash flows increase the investors’ purchasing power even as the rate of inflation is rising. Also, stocks tend to grow in value in the long term, and holding a diversified portfolio of stocks can protect investors from the declining purchasing power of money. For example, stocks purchased for about $1,000 now can be worth more than $100,000 in the next 10 to 20 years.

 

3. Diversify your portfolio

Another measure that investors can take to hedge against inflation is to create a diversified portfolio of stocks from around the world. When the US economy is experiencing a decline in the purchasing power of money, other economies such as Japan, Australia, and South Korea may be experiencing stable cycles that produce positive returns to investors.

Creating a diversified portfolio of stocks from other countries can protect investors from the declining purchasing power of money in the US market.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Diversification
  • Exchange Traded Fund (ETF)
  • Mutual Funds
  • Purchasing Power Parity

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