Over the march of time the value of money you have today will go down due to inflation. Every year inflation causes something you would buy today for a dollar to cost a dollar and a little more in the future. Over a long period of time this can drastically cut into the value of your bank and investment accounts. With inflation averaging around 3% over the long term the price of items doubles every 25 years. Something that costs you $100 today will cost you $200 in 25 years. This means your portfolio has to be armed to not only earn a healthy return for growth, but also to simply help you keep up with inflation.
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Investment Options to Hedge Against Inflation
With such a wide array of investment options out there, which ones will best protect you from the cost of inflation? Here are three potential investments to protect your portfolio from inflation.
Treasury Inflation-Protected Securities (TIPS)
TIPS, or Treasury Inflation-Protected Securities, are government backed bonds that are tied to inflation. These are extremely safe investments simply because they are backed by the US government.
How TIPs work is you purchase a TIPS with a set principal amount and you receive a fixed interest rate. The TIPS pays out interest twice per year. At the end of the year the principal value is also increased to whatever the inflation amount was during the year. A $1,000 TIPS that experienced 5% inflation in the first year would adjust up to $1,050 at the end of the year. Plus the investor would earn a fixed interest rate such as 3%, paid out semi-annually. This protects the principal value of the investment and gives the investor a return on top of it.
TIPS are one of the best and easiest ways to protect against inflation. There are two ways to buy TIPS:
- Directly from TreasuryDirect.gov or
- Through a mutual fund that targets TIPS investments.
For many investors the easier method if a mutual fund, even though that route increases trading costs, because TIPS are only sold in increments of $1,000. For individual investors trying to manage their asset allocations, picking and bidding on individual TIPS can be more complicated.
Inflation impacts all aspects of your budget and spending, but one of the biggest areas that can be impacted is your housing costs. Rents increase over time and home values slowly rise. However, if you own a home with a long-term fixed-rate mortgage, you can lock in your housing costs and never have to worry about inflation increasing the monthly cost. If you bought a home with a $800 mortgage payment on a 30-year fixed-rate mortgage, your first payment, 120th payment, and last payment will alway be $800. The value of your investment — your home — isn’t fixed to inflation like TIPS are, but if you maintain a buy and hold mentality (i.e., you never plan to move) then you can protect yourself from housing cost inflation through real estate.
Precious Metals and Commodities
One of the most popular investments over the last few years has been precious metals such as gold. You can’t go 24 hours without seeing a commercial on TV for a gold broker, passing a new gold exchange store on your way to work, or hearing about it on the radio. And for good reason as gold has enjoyed an incredible run over the past several years as the price has skyrocketed up. In the eyes of many, gold is the ultimate investment because gold is always valuable. A common argument is that hundreds of years ago a bar of gold would get you a closet full of nice suits, and the same is true today. As you research gold prices you will commonly see 30 year charts showing gold prices starting at $612 per ounce in 1980 and ending with current prices around $1,700 per ounce. That seems like an excellent investment: 300% over 30 years.
However, what those charts don’t show is that from that $612/oz. price in 1980 is that the price of gold didn’t exceed $612 until the 2006-2007 time frame. Prices went down after 1980 and dropped below $300/oz. for several years. If you bought in 1980 and sold 10 years later, you lost money and were not protected from inflation. Gold is the hot investment pitch right now, but it remains to be seen if it can really protect against inflation.
Do you invest in these inflation hedges? What other investments do you think are great at protecting against inflation?
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.