How to Profit from Inflation

Most investors are concerned about the effect inflation and the rising costs of goods and services can have on their portfolios. While a large amount of inflation can cause major problems within an economy, smart investors can effectively hedge against inflation to protect their investments. 

Our beginner’s guide to inflation will teach you a little more about what inflation is, why it occurs and how you can protect your investments when the value of the dollar falls.  

Define Inflation

Inflation can most simply be defined as “the decline in purchasing power of a currency over time.” As the general prices of goods, services and commodities rise over time, a single unit of any currency will buy you less of that good or service. Some people refer to inflation as the “rise of the cost of living.”

Let’s take a look at an example of inflation. In 2017, real estate database Zillow estimated that the median home price in the U.S. was $199,200. However, if you were to invest in a home in 1940, you’d likely pay just $2,938. 

This dramatic increase in price isn’t due to an increasing quality of homes — instead, it’s a product of inflation. As the price of the cost of living and building a property rises, developers and homeowners must charge more money when selling a property to stay in line with inflation and the current value of the property.

Inflation doesn’t only affect home prices. During periods of high inflation, the price of every service and commodity will rise. For example, in 1940, you could purchase a McDonald’s cheeseburger for just 19 cents and a milkshake for 20 cents. 

Today, the same meal prepared in much the same manner would cost you around $3.50. This is just 1 of many examples of how inflation affects how prices change and what you need to spend to invest with an eye toward the future. 

Though the idea of getting less bang for your buck might be frustrating, most economists consider a small amount of inflation to be an indicator that an economy is healthy. Small amounts of inflation encourage consumers to spend their money or invest it into assets that will appreciate over time to keep up with inflation. 

However, problems can occur during periods of hyperinflation (more than 50% inflation seen over the course of a month), when wages cannot keep up with inflation or when the costs of consumer goods outpace the general inflation rate. 

Measure Inflation

The United States Bureau of Labor Statistics uses a measure called the Consumer Price Index (CPI) as its primary measure to track inflation and how prices are changing over time. Employees working with the Bureau of Labor Statistics contact thousands of businesses across the country and ask about the prices of a selection of goods multiple times each year. There are over 80,000 individual consumer products included in the CPI — some examples include gasoline, a gallon of milk, alcohol, tobacco products and footwear. 

By keeping track of how prices for some of the most popular consumer products are changing year-by-year, experts can gain a more holistic picture of how inflation is affecting the country. For example, in February of 2020, the Bureau of Labor Statistics found that CPI data supported an inflation rate of about 2.3% between the years 2019 and 2020. This means that if a pack of gum cost you $1 in February 2019, the same pack of gum might cost you about $1.02 the next year as a result of inflation.  

Inflation Occurrence

There are 2 major causes of inflation: demand-pull inflation and cost-push inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when demand for a set of products is higher than the currently available supply of the goods. For example, imagine that unemployment within a select population has fallen and consumer confidence is up. 

In an effort to reduce carbon emissions, the federal government provides a tax credit for consumers who invest in an electric-powered vehicle. Suddenly, the demand for electric-powered vehicles rises, and auto manufacturers struggle to keep up with demand. In order to allocate more funds to vehicle production, the auto manufacturers raise the price of each vehicle. This effect spreads to other auto manufacturers, and the overall price of any type of vehicle (electric or not) increases.

Eventually, if consumer confidence remains high, this increased demand will trickle into other areas, causing the price of living to increase. Some of the most common triggers for this type of inflation include asset inflation, government spending, reduced interest rates and growing economic sentiment. Demand-pull inflation is the most common cause of inflation.

Cost-Push Inflation

Cost-push inflation occurs when increases in the price of raw materials forces manufacturers to increase the prices of goods, which then causes retailers to “push” this cost onto consumers. For example, imagine that an economic regulatory board imposes tariffs on the import of oil to a specific country. These tariffs make it more expensive to refine, import and distribute oil and gasoline within the country, and each company on the production chain must increase its costs in order to sustain their profit margins. 

Though the demand for oil and oil products hasn’t increased within the population, the price still increases because it is now more expensive to supply consumers with the same amount of oil that they need to use. 

How to Profit from Inflation

Most investors are concerned about the effect that inflation will have on their portfolios, especially if they’re investing for a long-term goal like retirement. Thankfully, there are a few assets that perform exceptionally well during periods of high inflation. Using these assets to diversify your investments can help you keep up with the rising cost of living as you plan for the future.  

Stocks

Though many stock sectors can see downturns during periods of high inflation, there are a few sectors that weather these periods better than others. If you’re concerned about rising inflation rates, consider adding stocks in these sectors to your portfolio.

• Materials companies. Material companies tend to hold onto a large amount of raw assets, which tend to increase in value during periods of high inflation. These companies can also easily pass increased expenditures along to its consumers in the form of higher production prices.
• Financial services. In order to combat inflation rates, the Federal Reserve often increases yield rates on bonds during periods of high inflation. This causes banks to raise their interest rates, which helps the financial sector keep up with inflation rates. Investments in banks and other financial institutions tend to retain value during periods of inflation as a result.
• Farm and agriculture-related companies. Like materials manufacturers, farm and agriculture-related companies directly produce the products they provide to wholesalers and retailers. This makes it easier for the company to pass along rising costs to purchasers, who then pass them onto consumers. A weaker U.S. dollar also makes it easier for farm-related companies to export equipment, which further helps this industry withstand inflation. 

Real Estate

Real estate has long been considered 1 of the most effective hedges against inflation. As the cost of living rises, real estate prices also tend to rise. In many areas, real estate prices even outpace inflation rates. 

For example, while the average home might have cost you $2,938 if you purchased it in the year 1940, the price in the year 2000 should be $30,600 if real estate prices had kept exactly in line with general inflation rates. Instead, the median home value in 2000 was $119,600. Similarly, as the value of land and real estate increases, the amount that landlords are able to collect in rent also increases with inflation.

There are 2 major ways that investors can add real estate investments to their portfolio:

• Direct real estate purchases. You can directly purchase a home, second home or investment property using a mortgage loan. Investors who purchase real estate directly may see a return on their investment from appreciation alone, or they might rent the space out to tenants.
• Real estate investment trusts (REITs). A REIT is a special class of company that owns or manages residential or commercial real estate properties. In most cases, REITs use the money collected from shareholders to fund real estate purchases and then return a portion of profits to investors through stock dividends. Investing in REITs can be an excellent way to add real estate to your portfolio without the expenses that come with purchasing and maintaining a property. 

Commodities

Commodities are basic goods that consumers buy and sell. Some examples of commodities include soybeans, corn, wheat and precious metals. Tangible assets tend to retain their value more effectively during periods of inflation because manufacturers and producers can easily pass rising costs along to purchasers as the value of the commodity rises and purchasing power decreases.

Gold is 1 of the most commonly purchased inflation hedges in the commodity sector.  Like real estate, you can invest in gold directly (by buying gold bullion or cubes and storing them in a safe place) or indirectly (by investing in a gold stock or exchange-traded fund ). 

Protect Your Portfolio

While our recommended inflation hedges have consistently shown strong performance during periods of high inflation, remember that there are no guarantees on any market. Some traditional inflation hedgers may suffer during periods of inflation, while other unlikely winners might emerge. 

However, history has shown that adding a diverse layer of traditional inflation hedges to your portfolio can help you make more effective progress towards your long-term goals. Take steps to protect your portfolio, and learn how to profit from inflation. While you cannot instantly profit from inflation, you can make investments that will help you leverage futures fluctuations in the market.