Fighting the Inflation War
Inflation is a much feared yet necessary evil of economic growth and development for a country.
There are a number of factors that contribute to inflation. These include rises in the production of raw materials like oil, increases in land acquisition costs due to hikes in real estate prices, or even unemployment. At times, when the demand for certain goods and services is much higher than the supply, this too can cause prices to increase - an example of inflation. Eventually, what all of this leads to is a decrease in the spending power of the currency.
As a result, while the amount of money one has in the bank is not decreasing, the purchasing power of the money decreases.
And so, what must one do about it? Well the first thing to do, could be to make sure your income is steadily increasing, at a rate higher than the rate of inflation. That way, even if an apple costs 5% more next year, you would still be able to comfortably afford it, because your income too has increased by at least 5% (hopefully more!).
The second solution to this problem is to protect your existing wealth, by investing in a way that the harms of inflation are reduced, if not completely neutralised. This article will discuss a few prudent ways to do just that.
However, the best way to reduce the damage that could come to you by inflation, is to practice a mix of both strategies mentioned above - aim for a steadily increasing income, while investing your wealth in a sensible way
1. Avoid High Amount of Long-Term Bonds
Bonds are fixed-income investments. The return received from your investment in Bonds depends on the fixed coupon rate. This coupon rate is not adjusted for inflation and will remain constant, up until the maturity date of the bond. As a result, the income you receive from interest payments will steadily lose value, because the purchasing power of the currency decreases on account of inflation.
This concept can be easily visualised through the following graph.
If the inflation rate rises up-to-the coupon rate of a long term bond, having a maturity period of say 30 years, the investor will start losing money. If you buy a 30-year bond that pays a 4% interest rate, but inflation goes up to 12%, you are in trouble with the bond. With each passing year, you are losing more and more buying power regardless of how safe you felt when you invested in the bond. The two effective ways of mitigating the impact of inflation on Bonds are the following
a. Invest in short term bonds - If the bond matures in a shorter period of time, the erosion caused by inflation is reduced, because the rate of inflation would have risen by a much smaller amount over a few months, rather than over many years
b. Invest in TIPS (Treasury Inflation-Protected Securities)- These bonds are recalibrated twice a year to account for inflation and deflation. As inflation goes up, the interest rate is also increased, accordingly.
2. Own Investments With Pricing Power
Some companies, owing to their business model, are capable of protecting themselves from increasing rates of inflation, bypassing the additional costs down to the consumers. A blood testing laboratory, for instance, may choose to increase the costs of its testing facilities, during times of high inflation. While this would certainly upset some customers, they would still have to get the blood test done anyway. Such hikes in selling prices for various services can also be done by a company when the demand for its goods is rising. In any way, piggy-backing on the safety net set by these companies is always a sound investment strategy.
A Glance at Commodities
Commodities, once again refer to a class of goods that can be considered to be “life essentials”. This includes items like staple grains - wheat, rice, corn, as well as goods such as oil, that power a country’s electric supply and large industries. As well as, precious metals like gold and silver, that are used widely in the manufacturing industry.
The reason these goods assume greater importance is because the ones with investments in these commodities, are the ones standing under an umbrella in the storm.
You see, while inflation may be erecting doldrums in various indie industries, like the Chemical Manufacturing industry or The Hospitality industry, the people still need to spend money in buying wheat and rice.
And industries will not be able to produce various equipment, without gold and silver - often a necessary hardware element. As a result, investments in these sectors have a higher degree of protection against inflation.
Smart investors add these commodities to their portfolios by investing in “Commodity EFTs” and “Futures”.
a. Commodity EFTS - or “Exchange Traded Funds''
Allow you to invest in various commodities, without having to worry about the physical ownership of these goods.
For instance, investing in futures trade in wheat, without an EFT, would mean having to stockpile bales of wheat in your apartment, along with barrels of oil and slabs of gold, should you choose to invest in those commodities as well - it isn't feasible. These ETFs consist of stocks or futures and derivative contracts that track the prices of the resource - without having to hold physical possession of these resources
When you buy a future contract, you sign an agreement to buy a trade in a commodity of your choice, sometime in the future. But the specialty of this contract is tht, today, you have specified the price at which you will buy the trade sometime in the future.
Now, if and when the price of this trade increases in the future (due to inflation or other reasons), you can buy it at a cheaper rate than its market rate. In this way, you have protected your wealth from the eroding effects of inflation. However, it is important to note, that if the price of the future commodity decreases, you would incur a loss instead of profit, and this is a gamble you have to live with.
All in all, it is always a good thing to account for potential losses that you may incur due to inflation. In this way, you can protect your wealth by hedging your losses and investing in smart ways such as those mentioned above.
However, just like everything else related to the stock markets, if you have something to gain, you also have something to lose, and there is no trade without risk!
Contact your financial advisor to understand how the above instruments can be used to best suit your financial portfolio and protect your wealth.