It’s generally thought that commodities are the best hedge against inflation, but is that really true? It actually depends on the kind of inflation we’re dealing with. Sometimes commodities can fill that role, other times they can’t.
Two types of inflation to be concerned with
One of the most basic problems in trying to deal with inflation is the fact that there are at least two types: gradual and acute. If you invest for one, your investment portfolio can get badly whacked by the other.
Gradual inflation is the stealthy kind of inflation that we live with most of the time, but don’t usually notice. We’ve actually been living in a period of gradual inflation for at least the past 20 years. During that time, we’ve experienced a consistent rate of inflation of between 2% and 4%, with the average right at about 3%.
Financial gurus are fond of saying that there is no inflation, but that’s hardly the case. An average rate of inflation of 3% will reduce the purchasing power of your portfolio by more than a third in the space of a single decade.
Acute inflation is the more noticeable kind of inflation because it’s effects are immediate. We usually think of this type of inflation starting at something around 5% per year, but it can easily go into double digits as it did during the 1970s. Under extreme circumstances, such as Germany in the 1920s or Russia in the 1990s, it can turn into a third kind of inflation – hyper-inflation – a level of inflation so severe that a nation’s currency becomes virtually worthless.
We’re not going to discuss hyper-inflation because it’s typically the result of catastrophic national events that are beyond the scope of this post. But it’s important to know the other two types of inflation that way you will be able to adequately prepare for each.
Protecting your investments from gradual inflation
It’s often said and thought that investing in commodities is the best way to protect your portfolio from inflation. But that’s almost never true during a time of gradual inflation. In fact, commodities can actually fall in price in a gradual inflation.
Growth type investments, such as stocks and mutual funds, are typically the best type of protection in a gradual inflation environment. Since stocks return an average of somewhere between 8% and 10% per year over the very long-term, that will easily outpace a 3% inflation rate, and keep your portfolio well ahead in the process.
Commodities tend to languish in periods of gradual inflation. That’s because periods of low-inflation are usually accompanied by increases in production of virtually everything, including commodities.
Protecting your investments from acute inflation
Acute inflation is an entirely different animal from its gradual cousin. The strategies that work in a gradual inflation often backfire when inflation reaches the acute level. For example, since inflation tends to cause interest rates to rise, stocks generally fall in a high inflation environment. This would make stocks one of the best places to not have your money in an acute inflation environment.
Commodities tend to shine in an acute inflation, upholding the notion that they are the best protection from inflation in general. In particular, energy and precious metals can do especially well during periods of acute inflation and will generally be the best protection for your investment portfolio. This is largely due to the fact that energy is a necessary commodity, and gold is the investment of choice during times of uncertainty. Since periods of acute inflation are usually accompanied by a general sense of crisis, both can attract an unusual amount of investment capital from around the world.
In an acute inflation, you would do well to increase your holdings of commodities, and reduce your stock positions.
Maintaining the right mix to deal with both inflation types
One of the problems with inflation-proofing your investment portfolio is that you can never know when a gradual inflation will turn into an acute inflation, or when an acute inflation will settle down into a mere gradual inflation. Maintaining a proper balance to deal with either situation is more than tricky.
During periods of gradual inflation, your portfolio should be dominated by growth stocks. But you should also have a small position – maybe 5% – in commodities just in case gradual turns into acute.
By the same token, even during times of acute inflation, you should also maintain a substantial minority position in growth stocks. You can never know when inflation will begin to taper, and that’s usually the best time to be in growth stocks since it represents the beginning of a long-term growth curve.
Inflation and fixed income investments – a mixed bag
Fixed income investments present a special dilemma when it comes to inflation. Since they are considered to be fixed value, they are also the assets that can be most depreciated by inflation. Though you should hold a measure of fixed income type investments in any type of inflation environment, you have to be careful specifically which you will hold in either an acute or gradual inflation.
During a gradual inflation, long-term bonds can represent the best type of fixed income assets to hold, particularly if the rate of interest that they pay comfortably exceeds the rate of inflation. This is especially true during periods of declining inflation, since a lower inflation rate will ultimately translate into lower interest rates, making the bonds even more valuable.
During times of acute inflation however, the better choice are short-term fixed-rate investments, such as certificates of deposit and money market funds. Certificates of deposit are typically too short in duration to be depreciated by inflation. But money market funds in particular are generally the best place for cash during an acute inflation. Since the interest rate they pay can move up with rising interest rates, you’ll not only participate in higher interest income, but the value of the underlying funds won’t decline the way that bonds will. Flexibility of interest rates in money market funds essentially protects the value from inflation.
Treasury Inflation-Protected Securities, or TIPS, represent a fixed income option in either a gradual or acute inflation. Issued by the US government, they not only pay interest, but the principal is periodically adjusted for inflation based on movements in the Consumer Price Index (CPI).
Where do you think inflation is heading, and how do you plan to arrange your investments to deal with it?