The best 5 ways to hedge against inflation: A guide for 2024

Inflation is characterized by a decline in currency value and a corresponding increase in the general price level of goods and services. While inflation is a natural aspect of economies, hedging against it can mitigate the expected decline in currency value and safeguard against reduced purchasing power.

Furthermore, inflation hedging can preserve the value of investments. Despite some investments appearing profitable, their real returns may diminish due to inflation.

To counter inflation, disciplined investors strategically allocate assets that perform well during inflationary periods. Although conventional bonds are favored by income-focused investors, alternative investments can also generate revenue streams.

Here are five asset classes to explore for shielding against inflation, spanning from stocks to fixed-income securities to alternative investments. Each presents viable options for individual investors, though they vary in risk levels.

1. Shift funds towards stocks

In case of inflation resurgence, while the bond market typically takes a hit, the stock market often sees a boost. To capitalize on this potential trend, contemplate reallocating 10% of your portfolio from bonds to stocks.

A 60/40 allocation of stocks and bonds is regarded as a secure and conservative investment blend. An illustration of such a portfolio is the Dimensional DFA Global Allocation 60/40 Portfolio (I) (DGSIX).

Another option is investing in preferred stocks, which offer higher yields compared to many bond types and may experience less price decline than bonds during inflationary periods.

Utility stocks provide a third alternative. Their stock prices tend to follow a somewhat predictable pattern throughout economic cycles and often offer consistent dividend payments.

2. Diversify internationally

American investors typically focus on domestic stocks and bonds, which may not always be the most cost-effective approach, especially during periods of inflation. Increasing exposure to international markets can serve as a valuable strategy for hedging against inflation.

Several major economies, such as Italy, Australia, and South Korea, don't necessarily move in sync with U.S. market indices. Adding stocks from these or similar countries to your portfolio can help diversify against domestic economic cycles. Additionally, bonds from foreign issuers can provide fixed income exposure that isn't as susceptible to price drops during inflationary periods.

Investing in international markets can be easily accomplished through exchange-traded funds (ETFs) and mutual funds. These options offer a low-cost alternative to directly purchasing a portfolio of American Depositary Receipts (ADRs) or foreign stocks. For those holding S&P 500 index funds, adding an international index fund to the portfolio could be a prudent move.

3. Explore real estate investment

Investing in real estate offers several benefits, including intrinsic value and consistent income from dividends. It serves as a reliable hedge against inflation due to the perpetual demand for housing. However, real estate is illiquid, prompting consideration of real estate investment trusts (REITs) as an alternative. REITs are more liquid and offer exposure to diverse real estate portfolios, often yielding higher returns than bonds. Additionally, they are less affected by rising interest rates due to stable operating costs. Vanguard Real Estate ETF (VNQ) is an example of a REIT providing broad real estate exposure with a low expense ratio.

4. Look to TIPS

Treasury inflation-protected securities (TIPS) are a type of U.S. Treasury bond designed to maintain their value in line with inflation. Being backed by the U.S. federal government, they are regarded as highly secure investments.

TIPS are tied to the Consumer Price Index, adjusting their principal amount based on changes in this index. They pay interest semiannually at a fixed rate applied to the adjusted principal. The principal increases with inflation and decreases with deflation. TIPS are available in three maturities: five-year, 10-year, and 30-year.

However, TIPS carry some risks, particularly sensitivity to changes in current interest rates. Selling TIPS before maturity may result in a loss if interest rates change unfavorably.

5. Investing in bank loans

Certain industries can benefit during periods of inflation, characterized by rising prices. For instance, banks tend to thrive as interest rates increase, capitalizing on higher loan prices and generating more revenue.

Investing in senior secured bank loans offers the potential for higher yields and provides protection against potential declines in value if interest rates rise. However, it's important to note that there might be a delay before the value of loans adjusts to rising rates. An example of such an investment vehicle is the Lord Abbett Floating Rate Fund (LFRAX).

What has historically been the most effective hedge against inflation?

The effectiveness of the best hedge against inflation historically depends on the timeframe considered. Commodities, especially gold, are often recommended for keeping up with the cost of living. However, research by Duke University professor Campbell Harvey and Claude Erb suggests that gold's effectiveness as an inflation hedge is most pronounced over very long periods—centuries or more.

Equities are considered by many analysts and economists to be a better long-term option for safeguarding a portfolio, particularly against unexpected inflation surges. This is because corporate earnings often grow more rapidly during periods of higher inflation, signaling increased consumer spending and economic expansion. Despite its fluctuations, the stock market, represented by the S&P 500, has demonstrated an average annual appreciation of 10% over the past century.

Is gold an effective hedge against inflation?

Gold has long been touted as an inflation hedge due to its tangible nature, which tends to preserve its value compared to fiat currencies like the dollar that depreciate during inflationary periods. While gold generally appreciates with rising inflation, it's not a foolproof hedge. Its prices can be influenced by various factors, leading to fluctuating returns that may not always align with inflation rates. In recent years, gold's nominal and real returns have shown inconsistency, with inflation not consistently driving its performance over various investment periods.

Does Bitcoin serve as a reliable safeguard against inflation?

Theoretically, Bitcoin could serve as a robust hedge against inflation. Assets like precious metals and real estate, typically sought after during periods of rising prices, are scarce or move counter to traditional currencies. Bitcoin aligns with these characteristics.

However, Bitcoin's limited investment history complicates its role as an inflation hedge. Having been actively traded for just over a decade since its creation in 2009, it lacks a comprehensive track record during inflationary periods.

As a result, predicting how inflation will impact Bitcoin, given its inherently volatile nature, remains uncertain. Recent trends have shown puzzling behavior regarding inflation. For instance, Bitcoin's value doubled from mid-December 2020 to early January 2021, coinciding with increasing inflation. However, it experienced a significant 25% loss in value between January 8 and January 11, despite ongoing inflationary pressures.

In May 2021, amid escalating inflation concerns signaled by the Federal Reserve's policy shifts and rising interest rates, Bitcoin experienced a pronounced decline. On May 19, it closed at $38,390, marking a substantial 41% drop from its mid-April peak of $64,829.

Does real estate serve as an effective hedge against inflation?

Real estate is widely recognized as an effective hedge against inflation. As a tangible asset, it tends to retain its value during inflationary periods, unlike paper assets. Additionally, rising prices typically lead to increased property values and rental income, benefiting real estate investors. Another advantage is the depreciation of debt, where fixed mortgage payments become relatively less expensive over time due to inflation. For instance, while mortgage payments may remain constant in nominal terms, their real value decreases as inflation erodes the purchasing power of money.

Inflation is an inevitable risk that all investors must contend with, as the value of money diminishes over time and economic conditions fluctuate. However, there are numerous strategies available to investors to mitigate the impact of inflation, including specialized investments and asset classes tailored for this purpose. By monitoring these assets and incorporating them into your portfolio when inflation becomes a concern, you can position your investments to thrive regardless of the prevailing economic conditions.