What Is an Inflation Hedge?

Inflation is the increase in prices of goods and services in the economy. This means that it gets more expensive to purchase things including groceries, apparel, and cars. Even monthly expenses like rent, insurance and your energy bill can cost you more. Inflation hedges are assets that perform well in inflationary environments and thus counteract the effects of high inflation.

The best inflation hedges are the safest investments that appeal to long-term investors with low risk tolerance. They offer a safe place for asset allocation amid rising inflation.

Current Inflation Environment

Probably to no surprise, you know that inflation is a hot button issue for many Americans today. As prices of goods and services keep rising in the U.S. and around the world, it puts pressure on consumers who are left with less income.

Inflation has been running rampant all year. The consumer price index (CPI) measures the average change over time in prices urban consumers pay for a market basket of goods. CPI rose 8.2% (seasonally adjusted) over the latest 12-month period, staying elevated at 40-year highs.

The phenomenon of rising prices has weighed on financial markets, too. The S&P 500 is down about 19% so far this year. Homebuyer demand is also down as interest rates are on a steady rise. And commodity prices have been volatile with the prices of oil and raw materials frantically swaying.

Best Hedges Against Inflation

Let's look at asset classes that are the most appropriate inflation hedges. Each offers unique characteristics that help preserve wealth during periods of rising prices.

Gold: The Ultimate Inflation Hedge

The yellow precious metal has been a time-tested investment. Gold has weathered inflationary environments well historically. Investors turn to gold and other precious metals for their characteristics that preserve investor purchasing power. They are therefore considered by many to be inflation-proof. Gold is a durable, tangible and scarce asset that has steadily increased in value over time.

But unlike gold miners and other companies, physical gold does not generate cash flow or provide dividend payments. Rather it serves as a store of value over a long period of time. While gold sometimes hasn't been living up to its potential recently, gold prices rose more than 7% over the last six months. Gold still remains in demand today.

Commodities

Commodities encompass various natural resources and agricultural products. Commodity prices are a solid inflation hedge because their prices tend to ebb and flow with the economy. Inflation, which has reached astronomical heights this year, has actually benefited commodities. This is because consumers and businesses use commodities such as oil, energy and natural gas, agriculture, among others in both good and poor economic conditions.

Crude oil has been one of the best performing commodities this year. West Texas Intermediate (WTI) crude, which serves as the global benchmark for oil, is up more than 9% this year-to-date, outperforming many other asset classes. Natural gas is another strong commodity performer this year. The S&P GSCI Natural Gas Index, which is a benchmark for performance in natural gas is up an outstanding 71.5% year-to-date.

Stocks

Stocks have historically held up well against inflation. In a diversified portfolio, stocks are the growth engine that help compound investment returns over time. However, stock investing comes with higher risk compared to the bond allocation of a portfolio. Stocks are subject to volatility and their values can fluctuate for a variety of different reasons.

In 2022, stock prices performed poorly. But taking a long-term view, stock market returns, on average, easily beat inflation. According to Investopedia, the average annual return of the S&P 500 since 1957 through December 2021 is 11.88% in terms of share price appreciation.

It's best to look at stock of companies that can still generate cash flow and maintain or even grow profits during recessionary economic periods. Consumer staples stocks like Walmart, Target, or Coca-Cola fall into this category. People will still need to buy products they use daily like toothpaste, shampoo, and personal care products regardless of how the economy is performing.

Real Estate

Another tangible asset, real estate is considered one of the best hedges against inflation because this market is strongly linked to the economy. As prices in the economy rise, income from real estate investments like rent tends to rise with it. For example, if you are a landlord of a rental property, you have the ability to increase the price of rent for tenants in different economic cycles.

However, real estate investing comes with its own risks. Investing in physical real estate is a long-term investment regardless of home prices—it's not easily bought and sold on the market like stocks. You also must pay property taxes. Furthermore, when interest rates rise (like they are today), demand for new real estate declines because homebuyer mortgage payments will be higher versus when interest rates are lower.

But you don't have to invest in physical real estate. Real estate investment trusts or REITs are companies that own or invest in income-producing properties. These securities are real estate stocks and can be bought and sold on a major stock exchange.

Treasury Inflation-Protected Securities (TIPS)

Investing in TIPS is another way to hedge against inflation. What are TIPS? TIPS are Treasury securities whose value rises and falls with the CPI, the measure for inflation mentioned earlier. This means that the value of your principal that's invested in TIPS will rise as inflation increases or adjust if there is deflation over the long run. In addition, you will receive interest payments every six month according to the fixed interest rate the bond is sold at, serving as profit for TIPS holders.

Another perk: As government bonds, TIPS are considered lower risk investments since they're backed by the full faith and credit of the U.S. government. On the flip side, bond investments tend to be lower yielding compared to the higher returns of individual stocks. You can think of TIPS as an insurance policy against short-term inflation.

How to Apply Inflation Hedges to Your Investing Strategy

Even if you're not an experienced investor, having some form of protection from the effects of inflation is important. Each of the options listed above is a good candidate for inclusion in your investment portfolio, depending on your financial goals. The pertinent question is: Which inflation hedge is the best of the best?

There is no clear-cut answer, unfortunately. Not every inflationary period is an exact copy of the previous one. As economic conditions vary, the performance of the assets listed above will likely differ from one another. Picking the ultimate winner is indeed a difficult task.

Conclusion

Protecting your wealth from inflation requires a strategic approach that combines multiple asset classes working together. While no single investment guarantees perfect inflation protection, a diversified portfolio including precious metals, commodities, quality stocks, real estate, and TIPS can provide substantial defense against rising prices.

The current inflationary environment presents both challenges and opportunities for investors. By understanding how different assets respond to inflation and implementing a balanced approach, you can position your portfolio to not just survive but potentially thrive during periods of currency debasement and rising costs.