Ask Americans to talk about the economy, and you’ll hear a lot about inflation—and for good reason. Prices today are 22.5% higher than they were before the pandemic recession began in 2020,1 and the rising cost of living has put the squeeze on consumers. While the Fed has made significant inroads toward taming inflation, the December figure was 2.9%, the highest reading since July.2
You could add inflation to the joke about the only certain things being death and taxes, because it’s a natural part of the economic cycle. But when it comes to inflation, it’s not just higher prices you have to worry about. Since inflation erodes purchasing power over time, it also eats into the real value of portfolio returns.
Inflation reflects the rising cost of goods and services over time, typically measured by metrics like the Consumer Price Index (CPI).3 Simply put, $100 today is not likely to buy the same amount of goods or services in 10 years, although $100 invested may.
It also means that when we talk about investment returns, we’re often missing an important caveat. For example, if your portfolio generates annual returns of 5% but inflation runs at 3%, your real return is only 2%.
It’s the counterbalance to investing early and letting compound interest do its work; inflation grows over time, making those dollars less valuable. Investors who want to preserve and grow their real wealth would need to find ways to hedge their portfolios against inflation.
Diversification is your best friend
One of the best ways to combat the impact of inflation on your portfolio, we believe, is diversification. This strategy invests in different kinds of assets that don’t tend to move together, so that when some assets have poor returns, other assets could have better returns. In theory then, at any given point, some of the investments would likely be doing well.
When inflation is low, investors can focus on assets that generate consistent income and benefit from stable price levels. Equities can be an attractive option, since with limited upward pressure on costs, companies may be more likely to maintain healthy profit margins—which could translate into increased earnings and higher stock prices. Historically, sectors like technology, with its potential for innovation, and consumer staples stocks that benefit from consistent demand, have tended to perform well during periods of low inflation. When inflation has been low, interest rates also have come down, making long-term Treasuries another potentially beneficial option. Low interest rates can boost bond prices, and Treasuries deliver steady and reliable income.
But there are other asset classes that have tended in the past to do well in inflationary environments. Diversifying your portfolio to include some of the following types of investments could help hedge your portfolio against inflation.
Commodities
Natural resources and raw materials, such as oil, wheat, and copper, have the potential to be strong hedges against inflation because historically they tended to drive inflation. Since commodities constitute around 35% of the CPI, their prices impact rising consumer and producer costs.4
Investors can gain exposure to commodities through exchange-traded funds (ETFs), commodity futures, or stocks of companies heavily tied to resource extraction. For instance, consider oil companies and agricultural producers, which often see rising profits in inflationary environments due to higher product prices.
Cyclical stocks
Stocks in cyclical industries, such as consumer discretionary, financials, and automotives, could perform well when inflation is driven by strong economic growth. As prices for goods and services rise, companies in these sectors can potentially enjoy increased revenue, which could translate into higher stock prices. These sectors historically have thrived during periods of economic expansion because consumers and businesses spent more, and companies in these industries often had the pricing power to pass on higher costs to end users.
That being said, we believe the demand for these goods is often elastic, meaning that when prices rise, consumers can tend to pull back on their spending. They may also use financing or credit, and as higher inflation often leads to higher interest rates, demand may also suffer.
Key examples of cyclical stocks could include large automakers, travel and leisure companies, and financial institutions. Remember that these stocks can also be volatile. When economic expansion slows and inflation begins to weigh on consumer spending, the stocks can retreat. All investing involves risk and may lost money. Once again, diversification is key and it’s wise to aim for a mix of cyclical and non-cyclical stocks.
Treasury Inflation-Protected Securities (TIPS)
Treasury bonds are typically less attractive during inflationary periods, as their low yields can be rapidly eaten away by inflation. However, Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds specifically designed to protect investors against inflation. The principal value of TIPS increases with inflation and decreases with deflation, as measured by the CPI. Additionally, TIPS pay interest twice a year based on the adjusted principal, making them a considerable option for conservative investors.
TIPS can provide a low-risk way to preserve purchasing power while supporting portfolio stability during inflationary periods.
Energy
Energy stocks have benefited significantly during past periods of inflation, as oil, gas, and renewable energy infrastructure often saw sharp price increases during those times. This sector can be particularly attractive when inflation is driven by supply constraints or geopolitical tensions, as global energy demand could remain robust regardless of macroeconomic conditions.
As a retail investor, you can gain exposure to energy through stocks, ETFs, or mutual funds focused on energy companies. Look to oil giants or renewable energy providers for investments designed to help ride the wave of rising energy prices.
Industrials
Industrials, another potentially less volatile sector, includes companies involved in manufacturing, construction, and infrastructure. These businesses have often weathered past inflation well because they provided essential goods and services that remained in demand despite rising costs.
With a growing focus on infrastructure development and renewable energy, we believe industrial companies that supply materials, machinery, or engineering expertise could be well-positioned to thrive. Manufacturing ETFs or individual stocks in this sector offer accessible ways to add industrials exposure to your portfolio.
Alternatives
Alternative investments, including real estate, private equity, and hedge funds, can also provide a hedge against inflation. Real estate, for example, has typically seen property values and rental income rise during past inflationary periods, potentially offering protection for investors.
Similarly, in some cases, private equity investments in industries like technology or healthcare could potentially outpace inflation by targeting high-growth opportunities. While alternatives may involve higher risk or limited liquidity, they could add significant diversification to your portfolio when approached judiciously.
Precious metals
Precious metals like gold and silver have long been regarded by many as go-to options for helping to hedge against inflation. This has become a common strategy as, historically, gold prices have often exhibited a negative correlation with the value of the U.S. Dollar.5 In our view, silver could serve dual purposes as both a precious metal and an industrial metal, providing additional diversification.
Investors can access precious metals through bullion, ETFs, or mining stocks. For example, gold-indexed funds or shares in miners offer exposure with varying risk profiles.
Helping to build an inflation-protected portfolio
Creating an inflation-insulated portfolio doesn’t necessarily require a massive overhaul of your investment strategy—just a few key adjustments. Here are some steps we think you can take to deploy these assets strategically:
- Prioritize balance: Aim for diversification across asset classes to benefit from various inflation-hedging opportunities. For instance, you might combine TIPS, precious metals, and energy stocks to create a multi-layered shield against inflation.
- Monitor trends: Stay informed about economic indicators like inflation rates and commodity prices. Reacting to these trends can help optimize your portfolio allocations over time.
- Leverage ETFs: Exchange-traded funds can offer accessible and cost-effective ways to gain exposure to historically less inflation-volatile asset classes. We believe ETFs targeting commodities, energy, and real estate have the potential to hedge inflation.
- Revisit portfolio goals: Review your portfolio annually and adjust your investment mix based on economic conditions, inflation trends, and changing objectives.
- Seek professional guidance: Helping to inflation-protect a portfolio can be complex. Consider consulting with a financial advisor to tailor asset allocations to your specific risk tolerance and investment goals.
The takeaway
Inflation is an inevitable part of the economic cycle, but its impact on your portfolio doesn’t have to be. By diversifying and allocating your investments among assets like commodities, cyclical stocks, TIPS, and industrials, you can seek to hedge your portfolio against inflation risk and pursue your long-term financial objectives.
Remember, in the face of inflation, preparation isn’t optional—it's essential. Consider speaking to a professional to create a robust, diversified portfolio designed for resilience in any economic environment.
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