How to protect your portfolio from inflation
Inflation is the silent wealth killer, with the potential to undermine a portfolio's purchasing power, even if it maintains positive year-over-year returns.
If your portfolio grows at 3% per year but inflation is at 4%, your wealth is declining in real terms.
As a result, it's important to know how your portfolio will fair if inflation rises, as well as what modifications you'll need to make to protect yourself.
So, what is inflation?
When the consumer price index (CPI) shows an increase in the price of goods and services, this is referred to as inflation. This can be due to an excess of demand vs supply, a deficiency of supply versus demand, or a mix of the two. Inflation has far-reaching implications for investment returns, beyond merely raising the cost of your products and services by a dollar or two here and there.
What Is an Inflation Hedge, and How Does It Work?
An inflation hedge is an investment that is thought to protect against the currency's declining buying power. It normally involves purchasing an item with the expectation that it will maintain or increase its value over time.
What are some good inflation-protection investments?
Stocks have historically been a strong inflation hedge, with some sectors performing better than others.
Companies are best positioned to adjust to inflation because they can raise their prices in line with inflation. Investing in corporate shares can make sense since, in many cases, they can pass on cost increases to customers while maintaining profit margins and stock prices. Investing in businesses, with diversification through managed investment funds, is a wonderful way to protect against inflation.
Residential Mortgage-backed Securities (RMBS)
Residential Mortgage-Backed Securities are bonds that receive income from the residential mortgage repayments of Australian households.
These RMBS bonds – which are usually available only to institutional investors - are issued by some of Australia’s strongest lenders including Westpac, National Australia Bank and Suncorp.
RMBS are ‘floating rate’, which means that the investments receive a fixed interest margin above the floating bank bills rate. This means that if cash rates start to increase in response to inflation, then the coupon returns of RMBS investments will also rise. Rising interest rates are a positive for RMBS distribution returns.
Firstmac is a major issuer of RMBS bonds, and also offers an RMBS investment fund called High Livez, which gives ordinary investors access to this asset class which is usually available only to institutional investors.
Find out more about High Livez.
Gold is the oldest form of inflation protection. If you invest in actual gold, however, you will incur additional charges for keeping and insuring coins and bullion, which will reduce your profits. Although investing in gold-focused mutual funds and exchange-traded funds (ETFs) can significantly lower these costs, it's crucial to keep in mind that gold's price is quite volatile, especially in the short term.
It's also worth noting that, because gold normally generates no income, its opportunity cost rises in a high-inflation environment, when alternative low-risk assets, such as bonds, begin to offer higher yields.
Infrastructure assets benefit from being regulated, either through formal regulatory regimes or through 'shadow' regulatory pricing procedures buried in revenue contracts. This is particularly frequent in the utilities industry, as well as several ports and airports. Because revenues are increased by inflation and contain allowances for recovering the cost of debt, these assets are highly resistant to increases in inflation and interest rates.
Australian Real Estate Investment Trusts (AREITs)
Companies that own and operate income-producing real estate are known as Australian Real Estate Investment Trusts (AREITs). When inflation rises, so do property values and rental revenue. An AREIT is a real estate investment trust that pays dividends to its shareholders. To target inflation even more specifically, you can invest in non-discretionary commercial property, such as neighbourhood retail centres, which have been found to perform well in high-inflation and low-growth settings, as tenants will continue to benefit from solid levels of foot traffic.
Residential Real Estate
In Australia, residential real estate has long been regarded as one of the best performing investments in a high-inflation environment. This is due to the fact that as inflation rises, property prices have tended to rise as well, increasing the amount a landlord can demand for rent. This allows you to keep up with the rising cost of living. As a result, investing in real estate is one of the most popular strategies to protect an investment portfolio against inflation.
Cash is the most susceptible asset class during periods of rising inflation. Whether you are retired or not, rising prices decrease the value of cash assets. A key technique for combating inflation is to reduce cash holdings.
As with all investments, it is important to thoroughly read all available information, and to speak with a qualified financial advisor before making any financial commitments.