Inflation can be a pain in more ways than one. Not only does it raise your cost of living, but it also crimps the economy, reducing new job opportunities or a chance to earn more. It works against investors too by making it more difficult for companies to reach their full profit potential.
Inflation doesn’t necessarily have to up-end your portfolio’s value, however. You can minimize its effect. In fact, some investors may even be able to take advantage of inflation.
Here’s a closer look at the top four things you’ll want to consider doing when inflation is high — as it is now — and is likely to remain high for the foreseeable future.
Overweight exposure to business in perpetual demand
Although higher prices broadly stand in the way of consumerism at the same time higher expenses force companies to cut their costs, some industries are more resilient to price increases than others.
Think food, electricity, and healthcare. People might hold off on the purchase of a new automobile when money is tight, or they may decide to turn a vacation into a staycation. But they’re not likely to stop eating or postpone an important medical procedure, even if it costs more to do so. Ergo, companies well-equipped to handle this headwind are names like grocery store chain Kroger (KR -0.74%) or utility outfit Southern Company (SO -0.32%). The majority of their operating or inventory cost increases are simply passed along to customers.
Underweight technology and growth stocks
Although nearly all analysts will agree there can be exceptions to the premise, plenty of analysts argue that most growth stocks — and technology stocks in particular — struggle when their cost of capital (borrowing) is high at the same time the potential returns on other types of investments are stronger than usual.
Numbers crunched by brokerage firm and mutual fund company Fidelity support the idea. Looking at the performances of the market’s biggest 3,000 stocks going back to 1961, Fidelity finds there’s only about a 40% chance tech stocks will outperform the broad market as long as inflation is above average.
Conversely, there’s roughly a 70% chance the technology sector will outperform the overall market when inflation is falling, or in deflationary environments, confirming the premise. These statistics tend to hold up about the same no matter how strong or weak the economy is at the time, underscoring the validity of the data’s interpretation.
There are always exceptions to this norm, of course. Just know you’re fighting the statistical odds if you own a growth or tech holding in an inflationary environment.
In this vein, while it’s tempting to steer clear of technology stocks now, the time to do so was several months ago. It looks like inflation is now finally being tempered, perhaps boding well for tech and other growth industries that rely on capital investments.
Overweight commodities and real assets
It’s such a well-circulated tip that it’s almost become cliched. Like any other cliche, though, this one has stuck around because the tip holds up.
The tip? Gold is — generally speaking — a great hedge against inflation. The tricky part is timing. Gold prices tend to move in anticipation of future increases in inflation more so than in response to current or past inflation data. That’s why you might want to perpetually hold something simple like the SPDR Gold Trust (GLD 2.91%) in your portfolio, since you often don’t know when you’ll want or need it until it’s too late to buy it at an advantageous price.
It’s not just gold, though. Most commodities and physical assets like real estate tend to fare well when consumer prices are high and/or rising.
Steer clear of long-term bonds in favor of short-term ones
Although inflation works against the market value of all fixed-income instruments, it takes an oversized toll on bonds maturing in the distant future. The further away the maturity, the bigger the adverse effect.
It’s a complex and convoluted dynamic. Here’s the simplified explanation: The Federal Reserve’s chief weapon against inflation is interest rate increases via the federal funds rate, which is the basis for interest rates on many bonds and other fixed income instruments. The future interest payments on existing bonds are fixed, and can’t be changed once issued.
To adjust the effective interest rates on this existing corporate and government debt to newer, higher levels to new buyers, the marketable value of these instruments is effectively lowered. (This has the effect of making the interest rates on older bonds and fixed-income instruments more reflective of newer, prevailing interest rates for comparable newly issued bonds.)
For shorter-term debt maturing on the order of three months to two years, it doesn’t matter much. When you’re talking about maturities 20 and 30 years into the future, however, the dynamic can take a huge bite out of those bonds’ market values.
Sure, you can hold them until they mature. The problem is, you’re probably holding bonds making interest payments at rates that don’t even keep up with inflation. Buying debt with shorter-term maturities minimizes this problem, and also gives you the best possible rate for those particular bonds at the time you’re buying them. When they mature, just buy more short-term bonds making then-higher interest payments.
Too complicated or time-consuming? Try a bond fund meant to do the work for you instead. The iShares Tips Bond ETF (TIP 0.21%) provides you with a basket of inflation-protected Treasury securities with values that automatically adjust to reflect the U.S. inflation rate. Something like the iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB 0.48%) would do the trick as well. This fund swaps out its ever-maturing debt with newer bonds while inflation is pushing up rates, offering you the highest-possible short-term interest rates available at the time on at least a portion of its holdings.