By Steve Tepper, CFP®, MBA
The financial topic du jour is inflation. Seems every financial news outlet and publication is pushing the narrative hard that we’re in a period of price increases we haven’t seen since the 1980s. One prominent politician recently commented that people need to win the lottery just to afford a tankful of gas.[1]
That statement may be a bit hyperbolic, but we’ve all seen inflation in prices—not just gas, but groceries, rent, and many of the other things we spend money on every day. Even Dollar Tree has raised prices. They’re Dollar-Twenty-Five Tree now.
Many factors can contribute to above-average inflation, and it is often a combination of several. Here are a few common causes:
High demand: When demand for products and services is greater than supply, companies can, and often do, raise prices. Higher prices reduce demand, but inflation is the result.
Cost of goods: Price increases at one end of a supply chain can have a ripple effect. When the cost of raw materials needed to manufacture products increases, companies will try to pass those increases along to distributors by raising prices, who will look to do the same when they sell to retailers and, ultimately, consumers.
Money supply: Governments and central banks use the money supply to control the rate of growth of the economy. If an “easy money” policy causes the money supply to increase faster than the supply of goods and services available to purchase, we go back to Cause #1: high demand.
We can debate which of these factors is contributing to current inflation, but a more important discussion is: What do we do about it? How do you protect yourself from the loss of value of the money you’ve worked so hard to save over your lifetime?
As with all investment decisions, you have many options. History and economic theory can give us clues as to which strategies we would expect to do well and not well during an inflationary period. Let’s look at a few:
Cash: Everything else being equal, there really isn’t a worse strategy to protect yourself against inflation than keeping your money in cash. We wouldn’t recommend the strategy when inflation is low—one dollar left in cash in 1990 would be worth about 50 cents today—and the numbers are much worse when inflation rises.
Simply put, with every increase in price, your cash buys less. You may mitigate other risks by moving to cash, like market volatility, but you are completely exposed to inflation risk.
TIPS: Inflation-protected Treasury bonds, called TIPS, are specifically designed to hedge against inflation. They pay a fixed interest rate similar to regular Treasury bills. But the value of the bond rises with inflation, so your initial investment does not decrease in value as prices rise.
While TIPS can be a valuable part of a portfolio, overconcentration brings a risk as well: The interest rate is very low (currently 0.13% on five- and 10-year notes). In fact, the current rate is so low, the actual return you get between now and maturity is actually negative!
Gold: A whole lot of people out there say gold is a great investment to hedge against inflation, and a lot of those people have something in common: They’re selling gold.
The historical record on gold is spotty at best. In the 1970s, according to Morningstar, gold’s return outpaced high inflation, but when inflation was milder in the 1980s, gold had a negative return.
Gold prices are about as volatile as stocks, but over the long term, gold’s return is lower than not only stocks but bonds as well. So when you see that commercial for gold—and you will—turn the channel!
Stocks: It seems counterintuitive, given that inflation news over the past few weeks has propelled the major stock indices downward, but the evidence is clear: Investing in a diversified portfolio of stocks is an excellent strategy to outpace inflation.
Overall, stock returns have exceeded average inflation, and the same outperformance is evident in periods of high inflation as well. This makes perfect sense. What drives inflation? Higher prices. Who benefits from higher prices? Companies selling those goods and services at higher prices, thus earning more money. What happens when companies earn more money? Their stock price goes up.
Note the stock strategy is not as reliable in an undiversified portfolio: Don’t try to pick winners. And diversification also includes geographic diversification: Inflation doesn’t hit all countries the same or at the same time.
Having a significant portion of your money invested in developed countries and emerging markets can offset the short-term impact of inflation in a single country.
1. https://www.youtube.com/watch?v=r1qql8KYoHw
Sources:
“Helping Clients Understand Inflation” by Scott MacKillop, Advisorperspectives.com, February 3, 2022.
“Beware the Hype When Investing in Gold” by Amy C. Arnott, CFA, Morningstar.com, July 27, 2020.