Beating inflation rate is the primary goal for anyone who wishes to increase their wealth. As bank savings cannot hedge against the rate of inflation, everyone is looking for investments to hedge against it and add the surplus to their retirement. Most investors are aware of the typical assets that can keep up with inflation. But most are oblivious to the barriers to the means of inflation protection. Therefore, to optimally beat the rate of inflation, investors ought to know whether their knowledge of inflation is well-grounded.
Inflation rates also affect your investments
A simple definition of inflation[1] would be a currency losing its value, and its impact on reality is the rising prices and buyers losing their purchasing power. It generally results from an imbalance in supply and demand for goods, but political, and natural disasters can also contribute to inflation. A state's objective is to ensure price stability by keeping the annual inflation rate under 2%[2], while encouraging consumer demand to keep the economy functioning.
While everyone accepts that the value of savings in a bank account will reduce over time, most tend to forget or choose to ignore that inflation also affects investments. The positive side of inflation is that an investor can take advantage of a particular asset class's rising rates. The con of it is that some investments may not generate sufficient income to cover the unavoidable deductibles, such as income tax and subsequent inflation of the revenue. As an investor, you ought to know the circumstances under which the asset classes are best apt to fight inflation. Below are some tips on how to beat inflation.
Investment tips to beat inflation
There are a variety of tips to conquer inflation. However, not all are suitable for everyone. Investment against inflation is one way to beat it, but even it has its own variants. Although there is no one best way to fight inflation, there are some steps you can take to prepare your investments against inflation:
- Choose your investment period
- Allocate your assets smartly
- Diversify your portfolio efficiently
- Get to know the non-traditional investments
Choose your investment period: long-term or short-term
There is a common consensus that fixed-income-based investments[3] perform poorly against inflation. However, such notions tend to ignore investment terms when it comes to proper hedging. Some investments tend to work better in the long run, while others are profitable for shorter periods. Investors need to research well into the periods before deciding.
For example, a TUM study[4] evaluated that Stocks are a good investment against inflation over a long period. This is because stocks' value moves with the prices of the indices. Higher inflation points to higher dividends and thus higher revenue. Future contracts[5] or commodity futures[6] are also excellent long-term investments against inflation for more than three years, and their positive outcome increases with increasing period.
Bonds[7] have a terrible reputation in the investment market due to their decreasing value[8]. Still, studies have shown[9] that Bonds have similar inflation-beating qualities as stocks in the long run, with the additional benefit of being cost-efficient. The same can be said for gold[10], which are not popular among investing enthusiasts due to their low returns. Still, studies show that it can hold against inflation in the long run, albeit partially because they depend on the monetary market, i.e. they may be out of fashion for people to use.
Real estate may be the only asset that may support all investment terms, depending on the investor himself. It carries the same inflation-beating characteristics as stocks and brings good revenue for someone investing for a short time. Studies merely confirm[11] the obvious that it beats inflation for both long-term and short-term investors.
Allocate your assets smartly
Whichever period you choose for your investment, you still need to consider how you should divide it. Allocating your investment assets is essential in managing your portfolio since it is a deciding factor for your revenues and, ultimately, beating inflation. The critical takeaway from asset allocation is that it should be dynamic, i.e., it should be mixed with different asset classes that balance your returns and risks.
Research shows that no single asset is a perfect way to protect against inflation. How well an inflation hedge works depends on how closely the return of an asset tracks inflation, how sensitive it is to inflation, how long it stays ahead of inflation, and how long it is held. But studies do show that an excellent way to allocate assets is to have a mix of stocks and bonds with an index in commodities futures (CF)[12] that can balance returns with risks in an inflationary atmosphere. Commodities deal with real assets, unlike stocks, and therefore have a definite correlation with inflation. Their prices move along with inflation, and consequently, they are stable. Oil and production-based indexes and CFs are excellent hedge options.
Some include real estate in their investments to better balance their portfolio to beat inflation. Since it is a tangible asset that appreciates with time, it is considered a first-class inflation hedge. Investors may choose a residential or commercial estate or both, but real-estate is low in volatility with high returns in both cases. On the other hand, studies show that real estate investment trust (REIT)[13] revenues are not correlated with inflation. Hence, investment in equity and mortgage REITs is not safe from it. Once an investor realises these factors, he will go on to allocate his assets smartly and efficiently.
Allocate smartly in your retirement plan
Pensions should not be ignored when it comes to hedging against inflation. Your retirement accounts are one avenue to invest in assets, such as stocks and bonds, at a lower management cost. Furthermore, your tax benefits also contribute to the hedging. Depending on your age, you should be able to decide how much or how often you want to invest in your pension. If you're getting close to retirement, experts say[14] you should keep putting any money you don't need right away into your pension account. For younger people, who have more time to recuperate from market flunks, they should focus more on investing in equities through their pension accounts.
Include value stocks in your asset allocation
You could also put some of your money into value stocks if you are young. In 2021, investors who were worried about the stock market volatility caused by the global pandemic turned to value stocks as a safe haven. Some investors see value stocks[15] as a safe bet because they have low prices but pay out a lot of money in dividends. In the five years after the dot-com bubble burst in 2000, value stocks did better by 16%.
Diversify your portfolio efficiently
Diversification is an effective strategy against inflation that every investor agrees with, but more than half of them do not know what it entails. Diversification does not merely mean spreading investment in all types of assets; it means diluting risk by avoiding investing in the same asset class or same risk characteristic. Adequate diversification is more likely to outperform inflation than over-diversifying. Investors must ensure that they prevent over-diversifying by investing in too many assets of the same class or with the same risk characteristics. This portfolio may bring in a large profit when the market is pushing the asset class upwards. Still, when the economy crashes, the indices will respond inversely to the same economic event, making this diversification expensive and completely obsolete.
A well-diversified portfolio would have a mix of index funds, exchange-traded funds, stocks, and real estate. But this is not the standard rule for investors to follow through no matter what. Investors need to be proactive and dilute their risks by choosing assets that are less likely to be affected by inflation.
Get to know the non-traditional investments
Being an investor means keeping an open mind to all forms of investment vehicles[16]. Do not limit yourself to typical investment types, as there are obstacles within these assets themselves that can bar you from entering the market in the first place. Barriers may include a high minimum capital requirement to invest, or they may not cater to your specific needs (short-term investment, for example, since most typical investments are for the long-term). This only pushes you away from protecting yourself from inflation. To get around those difficulties, you may want to look at some non-traditional investments that have been established, such as peer-to-peer lending[17], cryptocurrency, and crowdfunding[18]. These are unique assets as they integrate financial technology and automation, diversify, balance risks, and keep matters hands-off.
Cryptocurrency has become a multi-billion dollar asset class over the past few years due to its low transaction costs and blockchain use. Peer-to-peer lending became popular because it eliminated the middle man, who usually used to get the most out of the arrangement. Companies facilitate parties who otherwise have few options to borrow money and invest money. Investors can choose from loan types, terms, and borrower types. There are several well-known P2P lending platforms out there that have provided stable returns for investors of between 5% and 30%. Crowdfunding is another kind of investment that has allowed investors to invest in real estate or a business for an affordable capital amount. It enables investors to earn income on specific assets that they otherwise could not have afforded directly. Crowdfunding has been successful as a capital-raising model over the last 10 years, and it kicked off many businesses that are well-known today. The list is not exhaustive. There are countless variants of investments out there that can help to protect you from inflation.
What should you invest in to beat inflation?
Investors have a hard time figuring out what kinds of investments will give them better returns than the rate of inflation. It is important to remember that there is no one way to beat inflation, but there are many ways to lessen the damage that rising inflation can do to your investments and plans for making money. The following are some well known inflation beating investments that are well known. However, while they may not be the best investments for inflation protection, they do limit your losses in the long-term. We will also be looking at their actual performance in terms of research findings.
Beat Inflation by investing in gold
When it comes to fighting inflation, gold has a mixed track record. In the 1970s[19], when oil prices skyrocketed and the US monetary supply grew at an unprecedented rate, gold performed exceptionally well. For almost the entire last 40 years in the UK, gold appears to have provided some protection against an increase in the money supply. Gold returns can be predicted using CPI. However, gold generated negative total returns in the early 1980s[19] and underperformed large-cap stocks by a significant margin. The evidence that gold can be used as a hedge against inflation is, on the whole, weak. During the previous 15 years, gold's correlation coefficient with inflation has been just 0.07. Over the past three years, the correlation has dropped to a negative 0.26.
Invest in stocks to beat inflation
By analysing historical return data, investors can get a better sense of the market's performance during periods of high and low inflation. Inflation's impact on stock returns has been extensively studied. However, the research[20] has often yielded contradictory findings. Most academics have observed that increased inflation tends to lead to lower market prices. Studies show that as inflation rises, the price-to-earnings ratio of European stocks declines. This could be because corporations can partially pass on price increases to customers, but this is unlikely to be sufficient to hedge against the negative impacts of a rise in the market discount rate.
Beat inflation with real estate
According to some studies, real estate equities offer no protection against inflation. Real estate returns are negatively correlated with price increases, which suggests a negative impact on real estate returns when prices increase. The reason people still rely on real estate is that when inflation rises, investors modify their expectations.
Investing directly in real estate, however, provides a clearer understanding of the market. Inflation-adjusted returns on office and residential real estate outpace those on commercial real estate[21]. Residential real estate, in particular, has strong inflation hedging properties because there are very few alternatives.
Beat Inflation with inflation linked bonds
Inflation linked investments are some of the most suggested assets by investors. The principle and interest payments on inflation-linked bonds[22] are contractually tied to a nationally recognised inflation index. This helps shield investors from the negative impact of inflation. It is crucial for investors and consumers to examine the inflation hedging provided by inflation-linked bonds because they are all exposed to inflation. Bonds that are explicitly tied to changes in inflation are an efficient strategy to add explicit real returns to a portfolio because traditional asset classes like equities and bonds can be negatively affected by periods of persistent inflation. Having a direct link to the national inflation rate means that any rise in prices directly affects the principal value of an inflation-linked bond. Some issuers may employ a different method to calculate payments, but all inflation-linked bonds are meant to pay investors with returns that are legally linked to inflation.
In the United Kingdom, bonds of this type are tied to the retail price Index[23]. In Europe, the bonds are tied to the european harmonised index of consumer prices[24]. It is tied to the consumer price index[25] in the United States and they are known as treasury inflation protected securities. For governments, inflation-linked bonds are often sold in order to lower borrowing rates and increase their investor base.
Summary
It doesn't matter what you do, inflation will have an effect on your investments. While there are no solid inflation proof investments, they will limit the loss to inflation for a long period. There's no need to overlook the importance of a savings account in the event of an unexpected financial crisis, though. To ensure that you are well protected against inflation, choose a time horizon to determine which assets you need to invest in and stick to it. Manage your money effectively and diversify your investments so that if one asset loses value, the others don't suffer. This includes both your pension and value-added stock accounts. Non-traditional investments, such as peer-to-peer lending or crowdsourcing, can also be used to hedge against inflation. Investing in traditional assets such as stock market indices, real estate, government bonds, and gold may help guard against inflation, but none of them is guaranteed. Inflation can have a toll on even these assets at times. Yes, inflation is scary, but investing and decreasing investment costs, are all ways to stay ahead of inflation.
Inflation is unavoidable and, although important, it is not the end goal. Investing for inflation will put you ahead of the competition. Other factors, such as risks, returns, and liquidity, should also be factored in. With the help of fintech platforms, people now have the opportunity to afford measures against inflation.
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