Hedging Inflation

One of the primary goals of many institutional investors is the preservation of capital in real terms, and for individual investors it is building a portfolio that keeps up with the cost of living.

As inflation can be a serious problem for investors, they try to minimise the risk of inflation by "hedging". Hedging is simply the practice of investing in assets for the purpose of reducing or eliminating particular sources of risk in a portfolio. In this case, inflation.

Inflation during the during the 1970's was rampant. This led to a harsh stagflation period characterised by rising unemployment and rising inflation was only curbed globally when the US Federal reserve raised official interest rates. In Australia interest rates peaked in the high teens in the late 1980's and early 1990s. The subsequent recession caused by the lack of liquidity in the market affected a generation.

How to Hedge Inflation

During periods of inflation there is one truism - cash is not king.

If the inflation rate exceeds the interest rate then cash is devaluing. If you are reliant on a fixed cash income, such as a pension, then it just does not go as far. Whereas if you can buy assets whose increase in value exceeds the cost of borrowing the money needed to buy them then you cannot lose.

An investor might want to hedge against the risk of inflation by purchasing an asset whose returns are linked to the rate of inflation. Annuities or bonds whose returns are linked to the Consumer Price Index (CPI) will provide the investor with returns that increase when inflation increases. These types of assets are considered efficient hedges against inflation.

Gold is also employed as an inflation hedge. With gold stocks mostly unhedged  now, they are in a stronger position to benefit from a rising gold price. There is also the option of investors directly purchasing gold bullion via the Perth Mint.

These hedging strategies can keep your investment from losing its buying power, as inflation causes prices to rise.

However, ...

As at all times we suggest that investors maintain a balance of investments in their portfolio, even when adjusting for your own asset allocation decisions resulting from your own beliefs of the macro-economic picture.