Imagine you want to buy a toy. Your parents tell you that you can buy it next year. But the next year, when you go to buy the toy, it costs more money than before. That’s inflation.
Inflation is when the prices of goods and services, like food and clothes, go up over time. It refers to the declining value of money. This also eats away at the value of your savings and investments. If you’re not careful, inflation can make it challenging to reach your financial goals and maintain your standard of living.
That’s why it’s essential to know how to protect your money from inflation. In this article, you’ll find valuable insights and tips on how to hedge against inflation.
How Does Hedging Against Inflation Work?
Hedging against inflation involves investing in assets that can increase in value at a rate that matches or exceeds the inflation rate. For example, stocks, real estate, and commodities have historically been good hedging instruments. You can also invest in cryptos with attractive track records, like Bitcoin (BTC) and Ethereum (ETH).
Let’s take the story of a hardworking individual called ‘Ramesh.’
Ramesh had always been careful with his money. He saved every penny he could to live a comfortable post-retirement life. He parked all his money in a savings account that paid a fixed interest rate (Say 2% per annum). But as the years went by, the cost of living rose (Let’s say 7% per annum), and Ramesh’s savings couldn’t keep up. He found that his money could no longer buy the things he needed, and he struggled to make ends meet.
It’s because the ‘real’ value of his savings decreased due to the rising inflation rate. In Ramesh’s case, his savings lost around 5% of their value every year.
Ultimately, Ramesh learned that he needed to hedge against inflation to protect his wealth. It is a crucial strategy to protect your investments and purchasing power from the adverse effects of rising prices (inflation).
5 Best Ways to Hedge Against Inflation
The inflation rates have been rising globally since the end of 2021. Turkey experienced the highest inflation rate of 54.8% in the first quarter of 2022. Other countries like Israel, the United States, Japan, and the United Kingdom have also seen a significant increase in inflation over the past two years. It was mainly due to an uptick in food and energy prices in 2022.
Below are the top five financial instruments to safeguard oneself from this inflation crisis.
1. Equity
Stocks have been considered potential hedges against inflation because of their historical performance. The value of fundamentally strong companies often increases along with inflation. Also, though it’s not mandatory, these companies tend to increase their dividends in line with the inflation rate.
A fundamentally strong company has strong financials, such as high revenue and profit margins, low debt levels, and a solid track record of growth. These companies are well-positioned to weather economic downturns and are likely to continue to perform well in the long term. Other indicators include a strong brand reputation, a talented management team, a high-value proposition, and a competitive advantage in the market.
Asian Paints Ltd is a perfect example of a company with strong financial indicators that can increase its price in line with the inflation rate. Back in Jan 1999, its share price was INR 11.88, and currently, it stands at INR 2,775, experiencing a CAGR of 26.7%. In the same period, India’s average annual inflation rate is 12.5%.
2. Commodities
Commodities like gold act as a hedge against inflation because their price tends to increase when inflation is high.
There are several reasons for this, as mentioned below.
- Store of Value: Gold has been used as a store of value for centuries and has maintained its purchasing power over time.
- Limited supply: The supply of gold is relatively limited, making it scarce. Thus, as the demand for gold increases, its price tends to rise.
- Safe-haven Asset: Gold is often seen as a safe-haven asset that investors turn to during economic uncertainties. This increased demand can drive up the gold price.
- Relation with other assets: Gold has a low correlation with other assets. Thus, it can act as a perfect diversifier in a portfolio.
3. Cryptocurrencies
One of the most common contributing factors to inflation is the rise of the money supply within the economy.
Inflation occurs when money’s supply increases faster than the demand for goods and services. An increase in the money supply can result from the central bank printing more money or banks issuing more loans. Both of these actions can lead to an increase in currency circulation. When there is too much money chasing too few goods, prices rise, and the purchasing power of money decreases.
Luckily, cryptocurrencies that have limited supply and are decentralized can act as a safeguard against inflation. Limited supply is often used to ensure scarcity and prevent inflation in cryptocurrencies. Limiting the number of coins that can be created helps to maintain their value and stability over time.
Bitcoin (BTC), one of the most famous crypto, has a limited supply (21 million), and its value is determined by market demand. When the demand increases, it leads to a potential increase in Bitcoin’s value that can beat inflation.
4. Real estate
Real estate can also act as a hedge against inflation. There are a few reasons for the same.
- A rise in inflation increases the cost of construction materials, impacting the overall real estate price.
- A growing population increases real estate prices due to increasing demand.
- Other cyclical factors, including government policies and economic growth, can also increase the demand and price of real estate properties.
Moreover, real estate is a tangible asset that can provide a stable income stream through rent. If we take the Indian Real Estate market, the average return has been 10% over ten years. India’s average annual inflation rate is 7.8% in the same period.
But there are quite a few challenges while investing in real estate.
- The real estate market in India is highly regulated. The market can be affected by various factors, including government policies, economic conditions, etc.
- The process of buying and selling properties can be complex and time-consuming.
- It requires significant capital and may not be accessible to all investors.
An alternative to investing in physical real estate is to invest in Real Estate Investment Trusts (REITs). REITs own or finance properties such as offices, warehouses, and hospitals. Investors can earn rental income by investing in them. REITs’ average annual returns in India are between 7 to 8%.
5. Diversify your portfolio
Diversifying your portfolio ensures that you aren’t overly exposed to any one particular type of asset, safeguarding your money from inflationary pressures.
When diversifying, you must consider the different types of assets and how inflation may affect them.
For example, stocks, commodities, real estate, and cryptos have historically been good hedges against inflation because their values tend to increase along with the inflation rate. On the other hand, government bonds and cash may not be adequate investment mediums as their returns may not keep up with inflation.
The weight of each asset class in the portfolio should be determined based on the individual’s risk tolerance and financial goals. But, for your reference, below are some well-known rules for diversifying your portfolio.
- 50-30-20 rule: This rule suggests allocating 50%, 30%, and 20% to different asset classes based on your goals and preferences. For example, you can invest 50% of your portfolio in stock, 30% in crypto, and 20% in commodities.
- 100 minus age rule: First, subtract your age from 100 and calculate the reminder. Now, your portfolio should be composed of the number equal to your age in one asset class and the remainder in another asset class. For example, a 30-year-old investor would have 70% of their portfolio in stocks and 30% in crypto.
- 10% rule: Suppose you have invested in both stocks and cryptos. To reduce risk, no single stock should make up more than 10% of the total stock investment. For example, if you have invested in equities, no single stock should cover more than 10% of the total amount invested in equity. The same applies to crypto investment as well.
As mentioned, these rules of thumb are just a starting point and should be adjusted based on the respective individual.
Conclusion
As inflation creeps up, it’s wise to look at your finances and see if any tweaks can be made to safeguard your hard-earned cash. Putting your money into stocks, commodities, cryptos, or real estate can be an intelligent way to hedge against inflation. No matter what path you choose, spreading your investment around is crucial to reduce the risk of significant loss.
FAQs
1. Why is gold a hedge against inflation?
Gold is often considered a hedge against inflation because its price tends to increase when inflation is high. This is because it is a store of value, has a limited supply, and is considered a safe-haven asset by investors.
Please remember that gold prices fluctuate, and past performance does not guarantee future results. It’s also important to consider your own risk tolerance and financial goals before investing in gold or other inflation-hedge options.
2. Is Bitcoin a strong hedge against inflation?
One of the main arguments in favor of Bitcoin is its limited supply. There can only be 21 million BTCs in total, of which 19.27 million have been mined. In theory, this scarcity could drive up the price of Bitcoin as demand increases, which makes it a hedge against inflation.
3. Is property a good hedge against inflation?
The value of real estate tends to increase along with inflation. Also, real estate is a tangible asset that can provide a stable income stream through rent. If we take the Indian Real Estate market, the average return has been 10% over ten years. India’s average annual inflation rate is 7.8% in the same period.
But there are quite a few challenges while investing in real estate — Highly regulated, complex and time-consuming, expensive, and so on.
