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How to build a portfolio that beats inflation

The key to making money in an inflationary environment is to hold investments that increase in value at a rate in excess of the rate of inflation.

October 06, 2018 / 03:59 PM IST

Aniruddha Meher

Does the prospect of inflation affecting your purchasing power worry you? A few investment options like real estate, commodities, gold, stocks and inflation-linked bonds offer a hedge against inflation.

Consumer purchasing powers are adversely affected by inflationary environments due to sustained increases in the prices of various services and commodities.

According to Investopedia, “the key to making money in an inflationary environment is to hold investments that increase in value at a rate in excess of the rate of inflation.”

Commodities and hard assets share a negative correlation with stocks and bonds. During periods of high inflation, equities and bonds perform poorly, whereas the value of hard assets and commodities appreciates.  A number of investments such as real estate, gold, oil, inflation-indexed bonds and stocks offer what is known as a “hedge” against inflation because of their high intrinsic values.

Real Estate

Real Estate is a popular choice of investment especially due to impressive numbers. Not only do the prices of real estate increase over time, but also, real estate can be rented out to generate rental income. Moreover, the amount of rent paid by tenants can be increased over time to keep pace with the general rise in prices across the board. At the same time, the value of the property will have gone up too.

One of the biggest positives for investing in real estate is that capital can be preserved by doing so. However, with real estate, the property prices may also decline over a long term or just remain the same. Real estate may also incur recurring costs in the form of taxes and property maintenance costs. Tracking the fluctuations in property prices is not always as easy as tracing those of equity investments.

Commodities

Commodities offer protection against inflation as their prices go up during periods of high inflation. As demand for commodities of daily use increase, so do their retail prices as well as the cost involved in producing them.

An indirect means of investing in commodities is to invest in stocks of companies that are involved in the exploration, extraction, and sale of commodities; investing in gold mining equities for example. Miners provide an opportunity to invest in commodities below the surface when available at a discount to metal above the surface.” Such investments are equity-based investments and hence function like other securities that are traded on the international market.

It is also important to remember that not all commodity-based investments are effective hedges against inflation. It is advisable to conduct through valuations before investing in any commodity-based equities.

Gold

Gold is another popular hedge against inflation. The prices of gold have historically risen to record levels during inflationary periods as investors turned to the precious metal, thus sparking an increased demand. The Austrian School of Economics believes that eventually when the current debt-based economic system begins to fail, monetary arrangements will be changed so that some variation of the gold Standard will come back into global monetary arrangements.

Gold is also an extremely liquid asset to have in the form of coins or bullion. As gold is becoming increasingly financialized, there are now a variety of other ways to invest in gold like ETFs, gold mining shares and futures.

Stocks

Stocks have a reasonable chance of keeping up with inflation considering the fact that companies pass increases in costs onto customers. The key is to select individual stocks with higher dividend yields with stable companies. Companies with sustainable competitive advantages and high barriers to entry (Moat Companies) can ensure long periods of excess returns.

High Net worth Individuals should consider investing in equities through Portfolio Management Services (PMS). This ensures a high level of control over a portfolio in terms of asset allocation and diversity of investments.

Inflation-linked bonds:

Inflation-linked bonds are securities issued by sovereign governments like those of the U.S. and the U.K. to offer protection against inflation. They are indexed to inflation so that the principal and rates of interest increase and decrease depending upon the rate of inflation. Their principal and interest payments are contractually linked to a nationally-recognized inflation measure like the UK’s Retail Price Index (RPI) and America’s Consumer Price Index (CPI).

According to Global.pimco.com,” The earliest recorded inflation-indexed bonds were issued by the Commonwealth of Massachusetts in 1780 during the Revolutionary War. Much later, emerging market countries began issuing ILBs in the 1960s. In the 1980s, the UK was the first major developed market to introduce “linkers” to the market. Several other countries followed, including Australia, Canada, Mexico and Sweden. In January 1997, the U.S. began issuing Treasury Inflation-Protected Securities (TIPS), now the largest component of the global ILB market. Today inflation-linked bonds are typically sold by governments in an effort to reduce borrowing costs and broaden their investor base. Corporations have occasionally issued inflation-linked bonds for the same reasons, but the total amount has been relatively small.”

 The bottom line: The best hedge against inflation is what we term a ‘cockroach portfolio’ which can handle any kind of turmoil in the markets with assets that act, to a certain extent, contrary to each other. This means that a portfolio is invested equally across Gold, Fixed Income, Real Estate and Equities.

(The writer is fund manager of Sankhya India Portfolio at Multi-Act India)
Moneycontrol Contributor
first published: Apr 25, 2018 10:07 am