Hedging Inflation in Your Portfolio

fortpitt in Vault 22 May, 2013

Even as the Consumer Price Index (CPI) remains quiescent, the potential ravages of long-term inflation remain a concern among investors. At Fort Pitt, given our long-term, value-based investing approach, we want to remind readers that while policymakers seem determined to generate some low-grade level of inflation, perhaps 1-2 percent, real problems can still arise when inflation spikes above this range. With this in mind, it’s wise to avoid short-term thinking and implement strategies over the long-term that can hedge your portfolio against inflationary worry.

Stocks are generally a good inflation hedge, as active managements can react to inflationary impulses within the economy by raising prices and/or redoubling efforts to source and use raw materials more efficiently. A broad basket of firms selling products and services generally in demand can be valuable in outperforming inflation. That said, a rapid and sustained uptick in generalized inflation can severely impair Price/Earnings ratios. Equities therefore work well in periods of low to moderate inflation, but suffer badly if the CPI pushes much above 5 percent.

Aside from equities, a combination of other investments can be helpful as an inflation hedge, as outlined below:

  • Commodities. Often requiring a watchful eye given their ever-changing values, commodities can prove hedge-worthy given that their prices tend to rise as nominal growth accelerates.
  • Real Estate. The price of land should keep up with inflation over time. If you happen to need the shelter and can use a tax break, a house and a mortgage could be a good option as well, particularly with cost of long term mortgage money at historic lows.
  • Treasury Inflation Protected Securities (TIPS). TIPS offer an investor the relative safety of a US Treasury bond with the added benefit of the principal and coupon being adjusted for CPI. However, like regular US Treasuries, TIPS do have the risk that the principal value will decline as real interest rates rise.
  • Short-term bonds. Short-duration bonds allow an investor some yield in our current low-inflation environment.They also can protect you against severe principal loss should inflation accelerate. This is the opposite of the mortgage argument above. Now is the time to be a long term BORROWER, not a lender.
  • International/foreign investments. Buying mutual funds that invest in emerging or foreign markets can expand a portfolio’s reach and expose it to foreign currencies.

It’s important to hedge selectively for the long-term and to work with an advisor who can properly allocate your portfolio into each area that is appropriate and in line with your risk tolerance and long-term objective.

Check back to Ramparts, as we will continue to focus on inflationary trends and strategies that investors can consider.

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