Build a smart investment strategy to profit from inflation

Most economists attribute the recent uptick in global inflation to the recovery from the 2020-2021 Covid pandemic and the related disruptions in global supply chains. Surging energy prices are only adding fuel to the fire. 

As economies around the globe closed down and reopened due to the pandemic, the supply of certain goods was disrupted while consumer demand for them skyrocketed. Factory closures and transportations problems have upset global supply chains, further exacerbating the imbalance. Although most economists agree that inflation will not stabilize at current levels, there is a wide consensus that it will settle at higher levels than those seen prior to the pandemic. 

Central banks are responding to accelerating inflation with interest rate increases, which in turn are stoking fears of economic slowdown. This is an explosive combination of macroeconomic factors and investors need a carefully crafted strategy to ensure their assets are shielded from the damaging impact of high inflation and rising interest rates. 

Investors need to be on the lookout at times when consumer prices set out on an upward path. In addition to causing economic disruption, high inflation has a significant impact on the performance of financial assets. 

You may hear economists talking of real returns in the context of inflation. This is a very important consideration as the real return is what you earn on an investment after accounting for taxes and inflation. At times of high inflation, the real return on your investments typically declines, meaning that the profit you derive from the assets you invested in is smaller or can even disappear.

Money managers advise investors to rebalance their portfolios in times of high inflation and move more funds into assets that typically fare better when prices are rising. Before you set out to do this, one crucial factor you need to investigate is whether the uptick in inflation is temporary or permanent. If consumer prices increase because of a one-off factor, chances are that inflation will not be permanent and you may be better off riding out the storm without reshuffling your investments.

At times of high and rising inflation, like the one most of the world is experiencing in 2022, it is best to assume a proactive approach and search out the financial assets that have the highest chance of combating the negative impacts of inflation.

For every investor, the ultimate goal is to grow or at least preserve the value of their portfolio. As a rule of thumb, diversifying your portfolio - in other words investing in a range of assets - is a great way of spreading your risks and most experts will recommend using this as a hedge against inflation. 

Below we assembled a list of financial assets that fare better at times of high inflation. 

1. Inflation-linked bonds 

These securities are typically designed to help protect investors from inflation. ILBs are most often issued by sovereign governments and are indexed to inflation so that the principal and interest payments rise and fall with the rate of inflation. These bonds are typically available to retail investors in all major markets, such as the US or the eurozone. In the US, they are called Treasury inflation-protected securities (TIPS) and their principal value rises in tandem with inflation while the interest payment varies with the adjusted principal value of the bond. In the eurozone, retail investors can purchase euro-denominated inflation-linked bonds issued by various governments within the euro area. 

In addition to purchasing individual ILBs or TIPS, investors can also buy funds or exchange-traded funds (ETFs) that consist of such securities. Check out BrokerChooser’s selection of best brokers for bond trading in the US and for Europeans. 

2. Real estate 

Real estate can be a good hedge against inflation because property values over time tend to stay on a steady upward curve. The emphasis here is on the time horizon of your investment. The longer you hold on to a piece of real estate, the higher the chances your investment will bear sturdier returns. Similarly to all other sectors of the economy, the property market is also prone to ups and downs, so this investment is not without risks either.  Real estate investments can also provide potential recurring income in the form of rent collected and can keep pace or exceed inflation in terms of appreciation

As an additional means of getting exposure to the real estate market, you can invest in real estate investment trusts or REITs, These are companies that own and operate income-producing real estate. Alternatively, you may seek out real estate-focused ETFs to gain an even wider exposure. 

3. Commodities 

Commodity prices usually rise when inflation is accelerating, therefore investing in commodities may provide portfolios with a hedge against inflation. Raw materials including oil, natural gas, precious metals, wheat and corn are touted as a good investment in times of high inflation. The correlation between  the annual growth of the Bloomberg Commodities Index and the U.S. Consumer Price Index on a 10-year horizon is 0.73, which underscores the effectiveness of commodities as an inflation hedge. Although the transition to a carbon-neutral world will inevitably impact commodities and their role as an inflation hedge in portfolios, this is expected to be gradual.

4. Stocks 

Historically, stock markets tend to perform well in an inflationary environment but not all stocks fare well when prices are high. According to an analysis of data back to the 1920s by BlackRock, one of the world’s largest fund managers, equities perform well as long as inflation isn’t out of control ― over 10% for a longer period. In above-average inflation environments (5%-10%), value stocks have performed particularly well. Sectors that have weathered high inflation well in the past include energy, health care and financials.

Fidelity Investments recommends buying stocks that increase their dividends during periods of high inflation. Such stocks tend to outperform the broad market considerably, on average. The fact that a company pays a dividend means it is profitable and has excess free cash flow, qualities that may help to buttress its stock during challenging times. Keep in mind, however, that not all dividend-paying stocks are created equal or can provide the same level of performance against inflation.

Similarly to bonds, you may also choose mutual funds and ETFs designed specifically to combat inflation or ones that pool high-dividend equities. Check out our picks for the best stockbrokers and ETF brokers.

Index funds are also touted as safe bets against inflation as they are automatically diversified. For example, the S&P 500 has traditionally outpaced inflation. Most brokers will offer you the possibility to invest in these instruments. 

5. Gold

As a commodity, gold has historically been viewed as a safe haven in times of political and economic distress. While many still see this precious metal as a venerable hedge against inflation, there are others who claim the opposite. One thing is for sure: gold hardly ever brings spectacular returns in the short term, it requires patience and perseverance from investors. So if you have a shorter investment horizon, gold may not be your safest bet to combat rising prices. If, on the other hand, you are in it for the long run, you may also consider buying mutual funds and ETFs that own gold apart from getting the real thing itself in the form of  bullion or coins. Check out this article on how you can invest in gold.

Experts in the other camp argue that gold is only a good inflation hedge over time frames that are far longer than any of our investment horizons. According to research conducted by Duke University, gold has done a relatively good job maintaining its purchasing power only when measured over very long periods—a century or more. Over shorter periods its real, or inflation-adjusted, price fluctuates no less than that of any other asset. 

While there is no certainty that particular assets will outperform when inflation is high, some will surely fare poorly. The two financial instruments you should avoid in a high inflation environment are cash and fixed-rate debt instruments, in other words fixed-rate bonds.

Keeping a certain amount of liquid cash at hand is a prudent thing to do, however, you may want to invest these funds (beyond what you may reasonably need in case of an emergency) when inflation runs high. Keep your cash in a savings account, as earning a small interest is still better than no interest at all.

As a rule of thumb, inflation and fixed-rate bonds are arch enemies. When inflation runs high, the return on fixed-rate bonds declines in real terms, meaning when adjusted for inflation. No wonder that investors eye bonds held in their portfolios with suspicion when prices are rising. Especially if inflation is expected to persist, central banks will respond with interest rate increases. And this is bad news for bondholders, because there is an inverse relationship between interest rates and bond prices. When interest rates are rising, the price of bonds typically falls because the fixed-rate interest it pays becomes less competitive.

📈 Are you worried about inflation and its potential impact on your investments? Our Inflation page is here to help! Learn how inflation can impact your investments and discover practical ways to protect them with our beginner's guide to inflation.

What investment does well in high inflation?

Typically, the following investments protect against inflation: 

• Inflation-linked (or inflation-indexed) bonds
• Real estate
• Commodities
• Select stocks or stock indexes
• Gold (in the long run) 

How does an inflation-indexed bond work?

Inflation-linked bonds are specifically designed to protect investors from high inflation. The payout on these instruments increases or decreases along with inflation. In this way, bond holders are protected from the purchasing power erosion caused by inflation.

Are stocks a good hedge against inflation?

Stocks and stock market indexes are generally regarded as good instruments to buy at times of high inflation. Even though stock markets tend to be jittery when inflation starts accelerating, the anxiety usually proves short-lived. Make sure you select stock investments carefully in a high-inflation period, with specific focus on high-dividend stocks and certain industries that historically fare well at times of high inflation.