By Chris L. Meacham, CPA,
In April, the U.S. consumer price index was up 0.3, which is its largest increase in 10 months. This does not mean that inflation will pick up tomorrow. It could take time and could be gradual, but inflation is still something to be aware of.
One aspect of inflation that is important to understand is that the government changed how it calculated CPI multiple times, even within the past three decades, which means that inflation is probably higher than the CPI representation. For example, in 1998, hedonic regression, a method of estimating a product’s value, was introduced to the CPI by the government. Hedonic regression estimates an item’s value by reducing the item to its constituent parts and calculating the market value of the constituent parts. For example, according to hedonic theory, even though a television set may be more expensive than it was previously, the price of the television is going down, not up, because the quality is improved. In other words, prices are adjusted down to reflect quality enhancements. This might lead to understated inflation.
Even if inflation takes time and is gradual, it’s important to make investment strategies to hedge against inflation. Here are some strategies to consider:
If you buy a home and live in it long enough to pay off the mortgage, you’re likely to protect yourself against price appreciation. Price appreciation over a few decades should be higher than the inflation rate. Aside from your home, we continue to like investing in real estate because of its many benefits, including an expectation that it will perform well during inflationary times.
Commodities are priced in US dollars and tend to increase in value when the dollar falls because, for example, the Government tries to print itself out of debt.
There are no asset classes that are perfectly correlated to inflation, so it’s important to diversify and include some classic inflation hedges in your portfolio, such as commodities and real estate.
Shorten bond duration:
Interest rates tend to go up during inflationary times. Because bond prices go down when interest rates go up, your bond portfolio can get hurt when interest rates rise. Ways to hedge against rising interest rates include shortening the duration of your bond portfolio, investing in certain unconstrained bond strategies, adding selected credit play strategies, moving to floating rate loans and other strategies that hedge against rising interest rates.
Increase exposure to falling dollar:
As mentioned before, investing in commodities is one way to increase exposure to the falling dollar. You can also invest in stock market indexes of countries you believe will have appreciating currencies or by investing in foreign companies or U.S. companies that earn most of their revenue from outside the U.S.
Although the uncertainty around when and how much inflation will rise can be disconcerting, if you plan accordingly, inflation doesn’t have to affect your financial stability.