How to Inflation-Proof Your Portfolio. Here are 5 Things You Can Do...

There is a lot of chatter you hear these days about Inflation.

Surging inflation is expected to be a serious bottleneck for India's economy as the country battles a third wave of Covid-19 infections.

Rising prices have been a concern for India for over two years now and central banks around the world are worried Omicron could sustain inflation.

Most investors believe inflation will be a major roadblock for markets in 2022 and are worried about how investments across their portfolio may get impacted.

But there are ways to protect your hard-earned wealth from inflation's negative effects.

Not all investments are negatively impacted by inflation. All you need to do is find the right strategies to mitigate the effects of inflation on your investments.

Here are 5 ways to Inflation-Proof your portfolio

#1. Real Estate and REITs

Real estate is considered a hedge against inflation and can even be a potential earning opportunity when prices are rising.

It can be done in two ways.

First, there is direct ownership in which you own property and earn rent from it. As inflation rises, so do property values, and a landlord can charge a higher rent.

This results in the landlord earning a higher rental income over time. It's assumed of course, that the cost of maintaining the property doesn't outpace the rate at which the rents are increased.

In fact, someone who has purchased a property using a fixed rate of interest could also benefit during times of high inflation.

This is because for the owner, it's the opposite of buying a bond - you're paying the loan back with money that is becoming less valuable. At the same time inflation could be driving the value of your property higher.

Another option to invest in real estate is indirect ownership through a real estate investment trust (REIT).

REITs are entities that own and operate income-producing real estate. Property prices and rental income tend to rise when inflation rises. A REIT consists of a pool of real estate that pays out dividends to its investors.

REITs provide natural protection against inflation. Real estate rents and values tend to increase when prices do.

This supports REIT dividend growth and provides a reliable stream of income even during inflation.

#2. Precious Metals

Theory and historical evidence support the inflation-precious metals link.

Precious metal prices benefit from inflation and negative real interest rates.

Unlike paper currencies, you can't print gold or silver. There's always going to be a limited supply of it available.

Also, precious metals tend to retain their value even if the currency weakens.

Gold has value because of its scarcity and many modern uses. Gold is also intrinsically valuable because it's highly conductive. It's instrumental in countless industrial and electronic applications.

The symbolic value of gold is another major reason for its continued success.

Silver, in addition to being used for jewellery, has industrial value. This makes it a critical component in electronics and emerging technology.

During times of inflation, investors flock to stable, solid investments like physical gold and silver as a way to store their wealth. As a result, this demand boosts precious metal prices. This gives investors a hedge against inflation and the devaluation of their currency.

Traditionally, investors bought physical gold and silver in the form of coins, bullions or jewellery. However, there are newer forms of gold & silver investments nowadays, such as Gold ETFs and Silver ETFs (exchange-traded funds).

#3. Equity - Diversify with the right stocks

In theory, equities should offer a buffer against inflation.

This is because a rise in prices should correspond to a rise in nominal revenues and thus boost share prices.

In practice, the impact of inflation on earnings will vary by sector and its ability to pass on higher input costs to consumers.

Choosing the right companies to invest in is the key in times of high inflation. In general, businesses that gain from inflation are those that enjoy pricing power.

It would make sense to invest in companies that are able to raise their prices along with the rate of inflation (like FMCG & energy stocks). This can help them potentially maintain their profits, which can benefit investors.

Interest rates are generally increased to beat high inflation. In such times it makes sense to buy and hold value stocks which have strong current cash flows instead of growth stocks which have little or no immediate cash flow.

Value stocks have a higher intrinsic value than their current trading price. These are usually shares of mature, well-established companies with strong current free cash flows.

Growth stocks don't offer immediate returns or dividends, but they demonstrate the potential to outperform the market in the future. The promise of future returns becomes less attractive when inflation reduces the value of those potential returns.

In times of high inflation, income stocks could also underperform. This is because they pay regular and stable dividends which may not keep up with inflation in the short run.

Hence, it's prudent to consider how inflation fits into the larger economic picture.

As inflation fears ease, investors may reallocate funds to cyclical stocks. These are stocks of companies providing with discretionary goods and services. These stocks tend to outperform in a strong economy.

#4. Commodities

Investing in commodities always gains interest when inflation rears its ugly head. Research shows that commodities tend to be one of the asset classes that is most positively correlated with inflation.

Commodities also tend to be uncorrelated with the stock market. This could add a diversification benefit to an investor's portfolio.

Simply speaking, commodities are tradable raw materials or agricultural products. Metals, oil, grains, pulses, spices, and natural gas are all examples of commodities.

Investors see the intrinsic value in owning and trading commodities since they are critical for consumers in their day-to-day life.

During periods of hyperinflation, economic pressures push up the price of products and services, making commodities more expensive.

Investors hoping to put money into commodities have several different options for doing so.

They can invest in commodities in the form of futures contracts or buy them indirectly through stocks.

Commodity mutual funds and exchange-traded funds (ETFs) can offer a broad exposure to commodities without the risk of futures trading.

Investors should be aware that commodities are extremely volatile.

As commodities are based on demand and supply, even a minor shift in supply due to geopolitical tensions or conflicts can have a negative impact on pricing.

Be very careful and prudent when trading commodities.

#5. Bonds

When the prices of goods and services are rising, a bond's fixed income becomes less attractive because that income buys fewer goods and services.

Interest rates rise and bond prices fall when inflation rises.

Investors can hedge the immediate effects of inflation by allocating to short-term bonds that have frequently updated yields.

When interest rates are increasing, opting for shorter maturities enables investors to frequently roll over bonds at higher interest rates. This helps investors keep up with short-term inflation.

Another option for investors is a floating-rate bond. RBI launched a floating-rate savings bond in 2020. The interest rates vary and is linked to National Savings Certificate (NSC).

The rate is subject to change every 6 months but the bond will always pay 0.35% higher than NSC rate.

Mutual funds also offer floating-rate funds. These funds invest a minimum of 65% in floating rate instruments. Such bonds have a base rate plus spread. As the repo rates increase or decrease the yield changes accordingly.

Bottom Line

Inflation can cut into a portfolio just as much as any other form of risk. The declining value of the rupee can put pressure on stocks, as well as savings accounts and bond holdings.

The 5 asset classes mentioned above can be a safe way of avoiding these pitfalls and keep a wise investor immune from the forces of high inflation.

Warren Buffett once said the best things a person can do to protect against inflation are to sharpen their skills and work to be at the top of their field.

"If you're the best teacher, if you're the best surgeon, if you're the best lawyer, you will get your share of the national economic pie regardless of the value of whatever the currency may be," the CEO of Berkshire Hathaway had said at the company's annual shareholder meeting in 2009.

The hedge isn't just what you're earning now, but what you could be earning later on.

Since we're talking about inflation, do watch the below video where Co-head of Research at Equitymaster Rahul Shah shares his view about why the inflation drumbeat is getting louder day by day.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...