Inflation has hit its highest level in 41 years!
Gas, food, and home prices have risen far from pre-pandemic levels. Stock and bond prices have both dropped from all-time highs. Most of us are scared.
Investors under the age of 60 haven’t experienced high inflation until now. How should we invest during inflation? What can we do to protect and grow our investments during a time like this?
Here’s the good news:
Your investments should be fine if you are broadly invested in the stock market, own a house, and aren’t gambling too much in crypto or other speculative investments.
The general advice is to set your long-term investment plan and stick with it for years—even decades. But you might have a reason to make a small shift in your plan today if too few of your assets are positioned to grow with inflation.
I own several types of assets that usually perform well when prices are rising. This has kept me calm as markets swing up and down.
Here are the asset classes I own that protect me against inflation. Make sure you own enough of them as a percentage of your portfolio. Then keep buying (or rebalance) through market declines, and your investments will do well in the long run.
1 Real estate
Real estate is my favorite investment during inflation.
Inflation is a reduction in the value of money. When its value goes down, it takes more money to pay for building materials and labor to build a new home. It generally increases the price of empty land also. This makes existing homes more valuable since an existing home is always an alternative to a new home.
I own the Colorado home I live in. I also have 3 rental properties in Arizona. All of them have had large price increases with the run-up of inflation.
The home you live in is not technically an investment. You have been on the positive side of price increases, however, if you own it. This is no different to your net worth than the increases that rental property investors have benefited from. Real estate provides some wealth stability for all homeowners during inflationary times.
Rental properties are even more valuable, though. Landlords can raise rent as the cost of owning and maintaining a property go up.
Rents in Arizona have risen faster than inflation due to the additional factors of supply and demand. My rental cash flow has increased more than enough to cover inflation in the last couple of years as a result.
2 Stocks
Companies that perform well during inflation are those that can easily raise prices in response to higher costs. The business that a company is in, the competition within its industry, and the strength of its brand determine how well it controls prices.
For instance, a giant grocery chain like Kroger has a strong brand and sells many food items that its customers will continue buying in any economic climate. It will have an easier time passing costs on to customers than a small gift shop. The gift shop’s potential customers may save their money so they can afford rising food costs.
It’s important for a company to be able to increase its volume of business without much additional capital investment. This is according to Warren Buffett, who calls real estate a good investment, and utilities and railroads bad investments during inflationary times. See this article for more from Warren Buffett on investing through inflation.
2.1 Individual Companies
Trying to beat the market is challenging—even for professionals with a team of analysts. It requires finding well-managed companies with these types of advantages. But it doesn’t stop there. You then need to buy them at good prices. You might wait to buy a stock when its price goes down for reasons unrelated to the individual company’s performance, for example.
2.2 Index Funds
Individual company ownership is not the way that I invest.
I have an asset allocation strategy, and own companies of all types through broad index funds. And I don’t try to time the market. I only rebalance when the allocation drifts far enough away from my target.
The largest index funds in my portfolio are weighted toward a handful of giant tech companies in the US. So I also diversify in country and industry through international, real estate investment trusts (REITs), and utilities funds.
International companies focused on a different region of the world may experience inflation differently than companies that are focused on US customers. Most international business uses the US dollar, and the largest international companies compete for the same customers across the world, however. The most inflation and currency diversification comes from emerging market and small international companies for that reason.
Also, notice that utilities have performed relatively well in 2022. Although Buffet may be correct about their need for large capital expenses, this highlights why it’s so challenging to time the market. There are many more forces at play than inflation alone, and utilities are seen as stable investments through growing and shrinking economies. The demand for electricity and water will always be there.
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3 I Bonds
Series I Savings Bonds are a US government guaranteed way to preserve the value of your money. I wrote in detail here about I bonds, how they work, and how to incorporate them into your financial picture. Their interest rates look great right now compared to almost any other investment.
I bought the maximum amount of I bonds—$10,000 per family member—in each of the last two years. This helps me to sleep well at night when the market has declined 20% or more.
The money will be used to cover shorter-term expenses. I don’t consider it to be part of my long-term investment portfolio, but it’s smoothing the ride as I track my net worth this year.
Read this article for more about I bonds.
4 Gold
I was strongly against gold as an investment through the Trailhead and Ascent stages of my financial journey.
I’m now sitting at the Summit of financial independence. I’ve studied the work of several people who are smarter and have been around longer than me. And I’ve spent many hours analyzing and developing the PathwayToFI Model Portfolios.
At this point, I can see gold’s value.
The US government pegged the value of the dollar to gold at $35 per ounce from 1944-1971. President Nixon removed the “gold standard” at that time, and gold has since gone as high as $2,000 per ounce.
Gold has had some wild price swings during the last 50 years, and it does not correlate well with inflation. It is more correlated with US government spending, which theoretically will result in inflation as greater spending—and printing of money—decreases the value of the dollar. But it turns out that inflation and government spending are not 1-to-1 either.
I am still including gold in this list because of what it does well. Gold is uncorrelated with the stock market. Sometimes the correlation is negative. This means that gold tends to stay flat or go up when stocks go down.
This makes gold a great diversifier in a portfolio. It helps to reduce risk and again helps me to sleep better at night!
4.1 Bonds do poorly during inflation
Bonds are used more commonly than gold for diversification with stocks. In 2022, however, bonds have been much more correlated with stocks than gold.
In fact, bonds are a bad investment when inflation is driving the markets because interest rates will go up with inflation. When interest rates go up, people are willing to pay less for the lower interest bond that you bought in the past.
Figure 2 adds the average Treasury bond rates to the inflation data from Figure 1. This shows that bond rates follow inflation. We can expect them to go higher from here if inflation is not reduced quickly.
Interest rates go up when inflation gets high, and bond prices go down when interest rates go up.
On the other hand, if a recession occurs, bond rates will go down instead and bond prices will go up.
Because of the difference in how they behave and the fact that we cannot predict the future, it’s useful to have both bonds and gold in Summit and Descent stage portfolios.
5 Other investments that do well during inflation
5.1 Commodities
You can invest in commodities such as oil, corn, and silver through funds that hold futures contracts. I will not go into detail here about how this works.
What I will say is that commodities can perform very well while prices are rising.
The reason that I don’t recommend them, however, is that they perform poorly at almost every other time. After inflation is taken into account, commodities may have a negative effect on your portfolio in the long run.
Gold is considered a commodity as well. But I am considering it separately for several reasons.
- Unlike other commodities, gold does not go bad and does not get used up or consumed
- Funds such as GLDM physically hold gold rather than investing in a futures contract
- Gold is seen as a store of value—a currency that has been around for thousands of years that people can easily exchange for dollars, euros, or rupees at any time
5.2 Treasury Inflation Protected Securities (TIPS)
TIPS are similar to I bonds in that they are government debt instruments that track with inflation.
The main difference is that they can be purchased in funds and in held in brokerage accounts alongside your stocks and bonds. You don’t have to go to treasury.gov to open an account and hold them there. There also isn’t a minimum timeframe that you are required to hold TIPs. Because they can be purchased on the open market, and because there is no minimum holding time, TIPs are priced daily and their price is much more volatile than I bonds.
These characteristics make TIPS a better investment than I bonds if you want to hold them for 10 years or more. But I would not recommend TIPS as a long-term investment because many other assets such as stocks and real estate perform better after inflation.
Don’t hold TIPs in your retirement portfolio. They’ll end up reducing your investment returns in the long-run.
Summary
We have discussed many assets that you should consider investing in when inflation is high:
- Real estate
- Stocks
- I bonds
- Gold
- Commodities
- TIPS
Real estate and stocks will outperform inflation in the long-run, and should be held by everyone at every stage on the Pathway to FI.
Gold is a great diversifier for those who have achieved financial independence and who are already retired. Those investors will benefit by reducing sequence of returns risk.
I bonds are great for shorter-term savings that will be needed in the next 1-5 years.
Other commodities and TIPS do not perform well enough long-term after inflation, and are not recommended.
Own a high percentage of real estate and stocks, keep buying through dips in the market, rebalance annually, and be patient. This is a formula for building wealth that has worked for me and millions of others.
For more ideas on asset allocation, take a look at the PathwayToFI Model Portfolios by signing up for free at the bottom of the page. And feel free to contact me directly or on social media if you have any questions or comments.
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