Three Simple Ways to Hedge Against Inflation.

Ryan Modesto

With the vast amounts of liquidity flooding markets and record low interest rates leading to increased borrowing, many are expecting higher rates of inflation sometime in the future.  Understanding how one protects themselves, or even benefits, from potential changes in these rates can set an investor up for success if/when these expectations come to fruition:

Treasury Inflation-Protected Securities (TIPS): These are likely the simplest way to preserve wealth against inflation. These securities are issued by the U.S. treasury and can be purchased directly from the treasury or through an ETF. The initial amount of the security is adjusted every six months to match changes in the consumer price index. While the interest rates paid are low, there is potential for the cash flows from the rates to increase as they are calculated on the adjusted principal. The ‘cherry on the top’ with these securities is that the investor at least receives the initial principal, protecting from the risk of a deflationary environment. TIPS are likely worth discussing with an advisor for investor’s looking for an alternative to government bonds with a similar risk profile. While these are unlikely to result in significant gains, TIPS will at least preserve an investors buying power. More information can be found here: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips.htm

Commodities: Since inflation is the result of an increase in costs of goods, it makes sense that owning those goods would allow an investor to match inflation. Interestingly, the chart below that compares a broad based commodity ETF (DBC) and monthly inflation numbers (U.S. Inflation) may tell a different story. Between the volatility of commodities and the likelihood of government intervention creating inefficiencies, investors who are holding commodities as a hedge against inflation need to understand the inherent risk associated with this type of investment. 

Equities: Inflated prices should typically lead to inflated company values due to the goods and services that they are selling having higher values as well. While holding equities in general is likely a good strategy to protect against inflation, not all equities are created equal. Look for companies that operate as oligopolies and are able to easily pass costs on to the end user such as the telecommunications companies in Canada. Some other areas worth examining are waste management companies as they often have an ability to pass inflation on to the customer over the long term and ‘vices’ such as tobacco since, for better or worse, these companies can essentially charge whatever price they wish.  

Inflation is an often overlooked factor in investors’ portfolios and can erode returns over the long term. While the effects of inflation can occur without an investor realizing it outright, the effects will appear very real when a dollar today only buys fifty cents worth of goods 10 years from now. Having exposure to assets that increase with inflation should hopefully provide protection to a portfolio from an unexpected rise in the rate and at least mitigate the longer term, wealth eroding effects of inflation.

Ryan Modesto

Canadian MoneySaver Contributing Editor