Investing 101: Fighting Inflation

26 May

Posted in Investing 101 by Roger, the Amateur Financier No Comments

Today, in a very special Investing 101 column, we’re going to consider ways to help inflation-proof your portfolio.

Q: What is inflation?

A: That’s something of a complicated question. The basic definition is that inflation is an economy-wide increase in the price of goods and services. Remember all those stories your grandfather would tell about how milk used to cost a dime and a loaf of bread used to be a nickel? The higher prices of those items (as well as everything else, from candy to condos) is evidence of inflation.

Q: What causes inflation, anyway?

A: In the simplest form, inflation is caused by a rising supply of money in the economy. Think of money as a good that you can trade for other goods and services; how much money you need to trade depends on how rare it is. If the supply of money increases relative to other goods, you will have to trade more money to obtain a particular item. For a rather extreme example, imagine that in one year, the amount of money in the economy increases by ten percent while the supply of bread remains the same. If the price of bread started at $1.00, then after inflation, it would cost $1.10. This example shows an annual interest increase of 10%.

If we’re looking at the broader economy, inflation rates are usually determined by measuring the growth of a broad price index. In the United States, the Consumer Price Index (CPI), a basket of consumer good prices, is mostly commonly used. The average rate of increase is about 3-4% per year, which means that prices should double in about twenty years (although, a few years of higher than normal inflation could easily speed that up).

Q: What can we do about inflation?

A: On the national level, there are several possible techniques that can be used to control inflation. Adjusting the money supply, increasing the prime rate (making it more expensive to borrow money) and, in the most extreme cases, instituting wage and price controls all have the potential to fight inflation, at least when used properly. On the individual level, the best way to limit the troubles caused by inflation is by holding some investments that do well in inflationary conditions.

Q: Alright, what are some good investments to combat inflation?

A: The best way to deal with normal levels of inflation (the 3-4% average annual inflation rate) is to hold a diverse portfolio with a sizable portion of money in stocks or other investments that provide decent growth. To deal with higher inflationary rates, or simply to to provide a more explicit hedge against inflation, you could consider either I-Bonds or TIPS from the US Treasury; both provide a greater investment boost when inflation runs high.

I-Bonds are similar to regular Treasuries, but the interest they pay is a combination of a fixed interest rate for the life of the bond and an adjustment for inflation that is set twice a year. This inflation adjustment means that if inflation starts to increase greatly, so will the returns on your I-Bonds. (As an added bonus, if you choose to hold the physical bonds, they have pictures of famous Americans such as Helen Keller and Albert Einstein (presumably, after he immigrated) on them.)

TIPS, or Treasury Inflation Protected Securities, also provide inflation protection, but do so in a different way. They have a set interest rate, but the amount of principle in the bond fluctuates, depending on the current rate of inflation. As a result, the amount of interest you receive during the life of the bond, as well as the amount of principle you receive at maturity, will increase along with the rate of inflation.

It’s worth noting that although both of these types of Treasuries can protect you against inflation, they are treated much differently for tax purposes. The interest payments (and thus, tax liability) for I-Bonds can be deferred until maturity, while TIPS are taxed yearly on both the interest they yield and the ‘phantom income’ of the principle adjustments. Because of this, it is frequently a good idea to put TIPS bonds into a tax-deferred account like an IRA, or better yet, a tax-free Roth account, to avoid such taxation.

Q: What about commodities and real estate; aren’t they good inflation hedges?

A: Somewhat. Commodities and real estate are often considered inflation hedges because, as real, tangible items, they have intrinsic value, unconnected to their role as investments. Assuming no change in the demand, inflation will simply mean that more money will needed to be paid for them, increasing their value along with the rising supply of money. However, since there is no explicit connection between the returns on these investments and the rate of inflation, it’s possible that high inflation rates could cause the demand for real estate or commodities to drop, decreasing their value. This is not to say that you shouldn’t own these investments; but think of them more as diversifying your portfolio, rather than serving as inflation hedges.

That’s it for our discussion of how to fight inflation; hopefully, you’re all a little more prepared to combat its effects on your portfolio.