Key Takeaways:
- Inflation lowers your purchasing power; the value of each dollar declines in an inflationary environment.
- We need to protect our wealth against inflation.
- There are several ways to do so, including investing in real assets & commodities, ensure allocation to higher-return assets such as stocks, and consider other forms of a store of value (e.g., cryptocurrency).
- The key takeaway here is that one should have a diversified portfolio of assets that generate a return greater than inflation, so one’s wealth and standard of living is maintained.
As we all have experienced in various forms over the past decade, things get more expensive over time. That cup of coffee might have been $3 just a year ago, but now it’s $5. While we may have gotten used to the slight increases in prices over time, living costs have undoubtedly soared.
That is inflation.
Inflation is the general increase in prices that results in declining purchase power. Due to inflation, the number of things you can buy for one dollar a year from now will be less than what you can buy a year ago.
This characteristic means that our wealth is declining if it’s not growing faster than inflation. If inflation is causing prices to increase at approximately 2% per year and your wealth earns a 0% annual return, then that means your wealth is worth 2% less next year in real terms.
This is a terrible scenario where hard-earned wealth erodes.
Fortunately, there are actions we can take to protect ourselves from inflation. There are many specific actions one can take. We explore three below.
1. Invest in Real Assets and Commodities
Real assets, or tangible assets, are things with fundamental value that generally moves with inflation. An example is real estate properties. As prices move up, so do real estate and associated rents. Therefore, by investing in real estate or gaining exposure to real estate through publicly-traded REITs (real estate investment trusts), one gets some protection.
Commodities have also shown to have characteristics to be a hedge against inflation. Gold, in particular, is a commonly acknowledged inflation hedging asset.
2. Ensure a Reasonable Allocation in Higher Return Assets (e.g., Stocks)
Moving a portfolio to be more aggressive, which increases long-term expected returns, could be an effective way to combat inflation. This usually means increasing portfolio allocation to equities, such as stocks.
Stocks provide two primary benefits. One is that stocks appreciate in value over-time. While there are risks with individual stocks and near-term volatility with any stock, a diversified portfolio of stocks has shown to grow over-time. Another benefit is that some companies distribute earnings to shareholders in the form of dividends. These dividends create cash flow and wealth for owners.
3. Consider Other Alternatives (e.g., cryptocurrency)
There are alternatives to traditional assets that may be practical considerations.
While still in their early stages of adoption, cryptocurrencies have the potential to be a hedge against inflation as well. Some of the characteristics of cryptocurrencies, including limited supply, can make them a good store of value.
In addition to cryptocurrency, there are non-traditional alternatives such as wine, art, and collectibles investments that could prove to be a different way to store value. These are worth exploring with your financial advisor to see whether these alternatives have a place in your portfolio.
Conclusion
Inflation is a nasty reality that erodes wealth. We can take action to protect ourselves from inflationary pressure, and we explored three of the many possible options above. The main takeaway is to make sure one’s wealth is in a diversified portfolio that generates a sufficient return greater than inflation.
Disclaimer: The contents of this website is an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.