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How should inflation affect my investment strategy?

The inflation rate in the United States has been very low for a very long time. In both 2013 and 2014 inflation was less than 2%, the Federal Reserve’s target rate to maintain price stability. To find the last time the rate of inflation topped 5%, you would have to go back to 1990, when the inflation rate was about 5.4%. 

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The trouble with inflation, however, is that it can be hard to predict. High inflation often catches economists – and the Federal Reserve – by surprise.

While it looks highly unlikely that inflation will spike any time soon, investors who are planning for the long-term should be aware of the risk inflation poses to the assets in their portfolio, and the ways to protect against that risk.

Inflation Hurts Fixed-Income Investments

This is the number-one thing to know about inflation and investing. Fixed-income investments like treasury notes and bonds are generally seen as safe investment vehicles, perfect for the risk-averse investor. They promise predictable returns (that’s the fixed-income part) over a given period of time.

Inflation, however, can wipe out those returns. That’s because the interest rate paid by fixed-income investments is a nominal interest rate, which does not take inflation into account. A fixed-income investment’s real interest rate is the nominal rate minus the rate of inflation.

So if you have a 10-year treasury note with a nominal rate of 4% and inflation rises to 3%, the T-note’s real interest rate will be just 1%. Or, suppose inflation rose to 5%. In that case, your real interest rate would be negative 1%. In terms of purchasing power, your investment would lose value with time. Yikes!

Stocks and Real Estate Are Inflation Resistant

How should inflation affect my investment strategy?

The good news is that not all investments carry this inflation risk. While investments in the stock market and real estate market both have risks of their own, their returns aren’t directly negated by inflation like those of fixed-income investments.

In general, when price levels rise, so do real estate values and stock prices. They don’t do so uniformly, however, so it is hard to predict how any individual stock will perform in a time of high inflation (or in any period, for that matter).

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TIPS are Inflation-Proof

If stocks and real estate seem like too risky an inflation hedge, then TIPS may be the asset for you. TIPS stands for Treasury Inflation-Protected Securities. They are specifically designed to protect investors against inflation risk.

Like a typical fixed-income security, the interest rate on TIPS is fixed. The par value, however, is indexed to inflation. If you invest $1,000 in TIPS and inflation (as reflected by the Consumer Price Index) increases by 5%, the par value – the amount on which interest payments are based – will likewise rise by 5%, to $1,050.

Your interest payments will likewise rise. If the interest rate on your $1,000 TIPS is 10%, annual interest payments would rise from $100 to $105.

Don’t expect a 10% interest rate on TIPS, however. Because TIPS are perhaps the lowest-risk investment available, they also offer extremely low interest rates. As of August 2015, the market rate on 10-year TIPS was just 0.65%.

 What About Commodities?

How should inflation affect my investment strategy?

Commodities like gold and silver are typically considered a good hedge against inflation because their prices are directly tied to the value of the dollar. In theory, commodity prices should match high inflation step for step.

Commodities, however, are a fairly volatile asset. Even more so than stocks, their prices jump regularly and unpredictably. For that reason, investing in a single commodity like gold is a risky proposition – far too risky to serve as a reliable hedge.

Commodity index funds are somewhat more stable, but historical data on the returns of investible commodities indices only goes back to 1991. That means there is little information as to how investments in commodities indices perform during times of high inflation.

Related Article: Investing in Silver

Bottom Line

For the ultimate inflation hedge, TIPS are the way to go, but an inflation-safe investment with higher returns such as stocks or real estate will do just fine.

Photo credit: ©iStock.com/PeskyMonkey, ©iStock.com/shalamov, ©iStock.com/mbbirdy

Nick Wallace Nick Wallace studied Economics at the University of Washington. He enjoys getting people thinking about finances by looking at the numbers. Nick is a freelance journalist and data analyst living in Michigan. He still lends his economic and analytic expertise for SmartAsset's studies.
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