What is an Inflation Hedge?
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“Inflation Hedge” is a term we are hearing more about. It isn’t a new term but when inflation is nowhere on the horizon, we don’t hear it.
I think most people kinda sorta have a general idea what it means but if asked to describe it could be at a loss for words.
I’m going to describe it for you.
A “hedge” in investing is a way to reduce risk in your portfolio. The risk is that the value of your investments drops. There are different types of hedges for different scenarios.
Today with inflation at 8.5% (annualized), inflation hedging is a hot topic.
Hedging is like buying an insurance policy in the event something goes wrong. One thing that can go wrong in an investment portfolio is the inflation we are experiencing today.
Unexpected inflation can cause prices in both the stock and bond markets to drop.
To hedge the risk of falling prices due to inflation, investors can use different types of assets that will continue to hold value or rise in price as inflation rises.
Here is an example:
In March of 2020 the average price of a gallon of gas was around $2.00 nationally.
Today the average price is $4.71. In 2 years the price of a gallon of gas has more than doubled.
The reason the price of gas is up so much is due to several factors.
Today the energy sector is up 58% over the last 12 months, far more than the current inflation rate of 8.5%. The energy sector includes the stocks of oil and gas companies.
If I own energy stocks (and I do, full disclosure) the value of my stocks have risen more than the inflation rate.
Let’s say I spend $60 a week on gas. Over the course of the year I spend $3,120.00.
If I have $3,120.00 invested in energy stocks, and the price of the energy stocks is up 58%, I have effectively “hedged” the inflation rate. Gas costs more, but the higher cost is offset by the return I am receiving owning energy stocks.
Today we are experiencing an unexpected increase in inflation.
We have been used to a very low rate of inflation for a very long time, averaging 2%.
The rate of inflation is always quoted on an annualized basis. When we see that the inflation rate (as measured by the Consumer Price Index) is 8.5%, that means over the course of a year you will “lose” $.85 cents for every dollar.
The problem with an all-encompassing number like CPI is that there are no details. The 8.5% inflation rate comes from a basket of data that looks at the prices of thousands of different items . The change in price for all those items is aggregated and voila, inflation is 8.5%.
A closer look at the CPI tells us that there are individual items experiencing price declines, items where the price is unchanged and items experiencing price increases.
Without looking through reams of data, we can get a good sense of where inflation is having the most impact by looking at returns in different sectors of the market.
One good source is on the Fidelity home page:
Sectors & Industries – Performance – Fidelity
The problem with hedging inflation is that when inflation is unexpected, as it is now, by the time we know it, it is usually too late to start implementing a “hedge”.
Having an inflation hedge in place is expensive, just like paying for insurance that you never use.
Having an inflation hedge in place means that you must own inflation hedging assets ALL THE TIME , and those assets may not provide a good return when inflation is low.
This is a key point.
Treasury Inflation Protected Securities, also known as TIPS, are bonds that are linked to the inflation rate.
If there is no inflation, what type of return can you expect by owning TIP’s ?
Owning gold is often cited as an inflation hedge. But is it really?
The price of gold has not gone up in line with inflation although the price of gold has been relatively stable.
I suspect that due to the pandemic the demand for gold used to make jewelry dropped off significantly, causing gold prices to drop.
Gold is a hard commodity. It is real and tangible. In times of inflation gold will keep its value compared to stocks or bonds.
Another asset that is used as an inflation hedge is real estate or REITS. Again, property is real and tangible. Prices may come down, but real estate and property holds value.
And what about crypto? Crypto has been heavily marketed as an inflation hedge.
I don’t agree. As inflation has risen the value of crypto has dropped. In some cases tokens and the value of certain crypto currencies has been wiped out.
Crypto is not real and tangible. It is not a “hard” asset.
It isn’t easy or practical for most individual investors to implement inflation hedges.
The best way to have some inflation protection is to own small amounts (no more than 5% of your total portfolio value) of different asset classes that perform better in an inflationary environment than stocks or bonds.
Using mutual funds or ETF’s that invest in gold, commodities, TIP’s, and property (REITS) is a good place to start as both mutual funds and ETF’s have more liquidity than hard assets or individual bonds.
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
