3 Ways to Help Manage Your Inflation Risk
With the United States Government running record deficits, a common concern of many new investors is protecting their portfolio from high inflation rates. When the printing machines start churning out dollars 24/7, it's a fairly good guess that prices are going to increase as money becomes less valuable, shrinking in purchasing power.
How can you mitigate high inflation rates? What can you do to position your family's wealth in a way that you can sleep soundly at night?
There are no foolproof methods, but there are some things you can consider with the help of a good financial planner. If executed properly, they have the potential to reduce your risk from the effects of inflation.
Tip #1: Avoid a High Concentration of Long-Term Bonds in Your Portfolio
When it comes to worrying about the inflation rate, bonds are the most vulnerable asset class. In fact, just as a moth can ruin a great wool sweater, inflation can destroy the net worth of a bond investor. Often, by the time you notice, it is too late. This happens because most bonds receive a fixed coupon rate that doesn't increase. If you buy a 30-year bond that pays a 4% interest rate, but inflation skyrockets to 12%, you are in serious trouble. With each passing year, you are losing more and more purchasing power regardless of how safe you feel when investing in bonds. If you're interested in learning more, I explained this in an article called Is Investing in Bonds Safer Than Investing in Stocks?.
Tip #2: Own Investments That Can Increase Cash Flows
If costs increase, McDonald's can increase the prices they charge for Big Macs and fries, right? If costs increase, an insurance company can charge more in premiums, right? If costs increase, an apartment building owner can increase rents in most areas of the country, right?
These are examples of businesses that have some built-in protection from a rise in the inflation rate. If the investments you own have pricing power, you can survive bouts of high inflation without getting hurt too badly.
Tip #3: Own Commodities That Move Independently from Currencies
If you own a farm that produces commodities such as wheat or corn, oil fields that pump out crude, mines of gold, silver, or copper, or other assets that trade like commodities - think fine art or collectibles - you probably aren't going to need to worry about inflation as much as you otherwise would have. If people need oil, or wheat, or gold, they will pay for it in whatever currency you accept, even if we are back in the stone age, trading sea shells and feathers. I know of several extremely rich investors who were buying farmland in Canada a couple of years ago because they believed that the United States was going to suffer significant inflation and a much weaker dollar as a result of our out-of-control deficits. They knew that the ability to own farms producing commodities in a foreign country would provide them with a potential anchor.
The Bottom Line
The bottom line is that there are steps you can take to reposition your investment portfolio that may help defend against a loss in purchasing power.
Some investors may even find opportunities to profit from inflation. It's important to talk with your financial adviser to discuss these strategies more in-depth.
To learn more about inflation, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as:
- "What Is Inflation?"
- What Causes a High Rate of Inflation?
- What Are the Effects of Inflation?
- What Is an Inflation Index?
- Why Aren't We Seeing Inflation, Yet?
- How Can I Calculate the Expected Inflation Rate?