How to Profit from Inflation
Inflation, a sustained increase in the general price of goods and services, is a problem for consumers, as each unit of currency purchases fewer goods and services in times of rising prices and thus decreasing the purchasing power of consumers.
On the other hand, inflation can be viewed as an opportunity for investors, who can benefit from holding investments providing a return in excess of the rate of inflation.
There are several investment products that have been historically viewed as a good choice for investors in the inflationary environment.
Generally, real estate is viewed as a good hedge against rising prices as the buyer is benefiting not only from the increase in the resale price of the property but also from generated rental income, both of which are rising in line with inflation.
Investment in Real Estate can be made either directly by buying the property or indirectly by investing in a REIT (real estate investment trust).
Considered a classic hedge at times of rising prices as it historically tends to increase in value during inflationary environment.
Gold can be purchased both directly by buying a metal or investing in companies involved in gold mining. Moreover, investors can purchase mutual fund or exchange-traded fund specializing in gold.
On the other hand, however, there are economists that view gold as not a perfect choice for investment, as they believe inflation is already factored in the price of gold, which has substantially increased during the first decade of the 2000s.
This product is a popular way to hedge risks against inflation, even considered more efficient than gold by many specialists. Other commodities such as gas, cotton, soybeans also tend to move with inflation.
The most convenient way to invest in commodities is through ETFs (exchange-traded funds), as it doesn’t require holding the physical commodity. However, these funds can pose significant risks, as they often face contango, a process when the value for a future delivery is higher than the current price of the commodity.
A good example of severe losses faced by ETFs when buying new contracts in times of rising prices, was in 2009 when the natural gas prices increased 3.4 percent, but the United States Natural Gas Fund dropped 56.5 percent as a result of rolling over futures contracts.
Bond prices have an inverse relationship to interest rates, which tend to increase the inflation rate, and thus reduce the bond value.
That is why, investors prefer bonds indexed to inflation, for example, TIPS (Treasury Inflation Protected Securities) in U.S., which is considered a classic inflation-indexed investment.
These bonds are linked to the Consumer Price Index and thus increase in value (both the base value and the interest payments) when the index rises.
TIPS can be purchased directly via a brokerage account or indirectly through mutual funds and exchange-traded funds.
One other way to use bonds as an inflation hedge is to build a bond ladder, that is buy bonds that mature in, for example, two, four, six, eight and ten years, and reinvest the proceeds from the maturing short-term bonds into longer-term bonds at higher rates.
Investors generally look for companies that have a high pass-through rate on to their consumers and thus being able to keep pace with rising inflation.
Another way is to invest in small-company value stocks that are generally highly indebted companies and benefit from the fact that the inflation reduces their liabilities.